Why muni bondholders may take it in the teeth after all

Meredith Whitney was a little off her game when it came to the municipal bond market. But she may yet be vindicated — not because of her prediction of mass defaults, but as a result of the red flag that she raised about the financial state of cities and towns. “She got the analysis of the situation right, in terms of budgets and the fiscal stress on local governments,” Matt Fabian, managing director of research firm Municipal Market Advisors, said of Ms. Whitney, chief executive of Meredith Whitney Advisory Group LLC. “But bondholders are at the top of the pile [of stakeholders.] Local governments really have to be under duress before they hit bondholders.” The outcome of several bankruptcy proceedings, however, could change the default landscape dramatically, said David Dubrow, a bankruptcy lawyer at Arent Fox LLP. Alabama’s Jefferson County filed for Chapter 9 municipal bankruptcy protection in November and is arguing in court for the right to cut payments on some $3 billion in bonds issued to fund its sewer system. Harrisburg, Pa., filed a month earlier because of massive debts from an incinerator project. Stockton, Calif., may soon become the largest city to declare bankruptcy in U.S. history. It is in a 60-day mediation period. Copycats If these issuers come out of their situations in better condition, it could encourage other stressed municipalities to follow suit. “If some of these entities are successful in restructuring collective- bargaining agreements and paring their debt, it may become more acceptable for others to try — and we’ll see more bankruptcy filings,” Mr. Dubrow said. The stress on muni issuers is getting worse. Local governments’ two major sources of revenue — income taxes and property taxes — have been hit by the weak economy and the collapse in real estate prices. And the liability side of the equation looks even worse, with huge obligations such as Medicaid, employee health care and pension costs becoming increasingly hard to meet. With post-crisis stimulus spending by the federal government petering out and austerity measures likely around the corner, the fiscal problems will put additional pressure on local governments. “Everything flows downhill to the local level,” said Naomi Richman, a managing director in public finance at Moody’s Investors Service. “The trade-offs are getting tougher, and the cuts are now really starting to hit.” Negative ratings Moody’s has a negative credit outlook for U.S states and local governments as a group, with the weak U.S. economy cited as the biggest risk of further deterioration. Admittedly, very few muni issuers have taken their troubles out on bondholders. The Rhode Island Legislature, in fact, passed a law last year preventing municipalities in the state from doing so. It gives holders of general-obligation muni bonds first lien on the issuer’s assets in the case of a Chapter 9 municipal bankruptcy. Bondholders are effectively protected in Rhode Island. In the case of Central Falls, R.I., which filed for Chapter 9 bankruptcy protection last July because of $80 million in unfunded pension and retiree health benefit obligations it couldn’t cover, the town’s pensioners got whacked — not the town’s creditors. Their benefits were cut by 50%, while bondholders suffered no losses. Few states are going as far as Rhode Island to shield lenders. But most muni issuers are doing everything they can to avoid defaulting on their bonds. They are slashing budgets, cutting jobs and raising revenue. The wave of defaults anticipated by Ms. Whitney last year was more of a trickle, with 124 issuers defaulting on a total of $6.41 billion in debt, according to data from Municipal Market Advisors. Most of those borrowers were unrated issuers, and a high proportion of them were entities in the health care and housing development sectors. According to Moody’s Investors Service research, just 71 rated issuers have defaulted in the United States since 1970, and just five of those defaults were on general-obligation bonds. Fifty-one of them were in the housing and health service sectors. The level of defaults in the muni market, while higher since the financial crisis, remains very low. Rewriting contracts “[Ms. Whitney] was accurate identifying the fiscal trends, but her conclusion was wrong,” said John Loffredo, co-portfolio manager of two muni bond funds — one investment-grade and one high-yield, for Mackay Shields, a division of New York Life Investment Management Holdings LLC. “She didn’t take into account the ability of states and municipalities to rewrite contracts.” Although Mr. Loffredo expects the number of defaults to increase this year, he thinks that they will remain lower than in the taxable-bond market. Strong demand and limited supply of muni issues this year will help the market. So would a raise in tax rates next year, which would make tax-exempt munis more attractive to investors. Mr. Loffredo favors the BBB market, where he expects spreads to narrow this year, while holders of investment-grade bonds likely will just get their interest coupons. “We think it’s going to be choppy for the next 12 months,” he said. “But we’ll end up about where we are now.”