The Hidden Bankruptcy Sector

By Sara Glakas

On May 24th, an article in Time asked if municipal bonds could be "The Next Financial Land Mine."

Richard Raphael, executive managing director of Fitch Ratings says, "This is the worst downturn…and most pressured environment for municipals in decades."

Municipalities have already defaulted on $6 billion worth of bonds in 2010, and 90% of restructuring experts polled by AlixPartners LLP believe a major U.S. municipality will default on its debt in 2010.

The market seems to agree. Growing credit spreads and higher prices for insurance against default are both indicating that sophisticated investors are starting to hedge against a municipal market meltdown by short selling bonds and buying default protection. According to the Wall Street Journal, financial institutions and their clients have been buying credit default swaps (CDS) or short selling the bonds of over a dozen states as well as towns, cities, toll bridges, highways and tunnels.

But while hedge fund managers and Wall Street strategists are able to smell the blood in the water, the Moms and Pops that have traditionally considered municipal bonds a safe haven may have no idea of what could be right around the corner.

The $2.8 trillion municipal bond market helps states, cities and local governments fund everything from sports stadiums to highways. The borrower pays back the bonds with taxes collected on property, sales and income.

The Historic Safe Haven
The default rate on municipal bonds has historically been less than 1 percent, compared to nearly 13 percent for corporate bonds. With a track record like that, no wonder municipal bonds are considered a safe place for conservative investors.

And because of the tax advantages of municipal bonds, wealthy individuals, retirees, pension funds and other institutional investors have piled into the sector in anticipation of rising tax rates. Nine states have already raised income taxes, and the Obama administration has made it a priority to effectively raise federal income tax rates by letting the Bush tax cuts expire next year.

So in search of safety, yield and a tax-shelter, millions of investors have paradoxically piled into a class of bonds that only get repaid if local governments can collect 1) property taxes on appreciating house values, 2) sales taxes on the purchase of consumer goods, and 3) income taxes on an employed population. 

So it's obviously a problem when you consider that almost all jurisdictions have declining revenues from all three of those sources. According to the Census Bureau, in 2009 total state tax receipts were down -11.3% from a year earlier.

Will the Government Bail Out the Governments?
We all know about the huge deficit problems in the states of California, New York and Illinois. Add to those colossal problems the smaller, but growing number of cities that are on default watch, some of which may be left with no choice but to file Chapter 9 bankruptcy.

Earlier this month, former Los Angeles mayor Richard Riordan claimed in an editorial in the Wall Street Journal that L.A. will likely have little choice but to declare bankruptcy between now and 2014.  The city joins Detroit, Las Vegas, Phoenix, Miami, Orlando, Jacksonville (FL), Harrisburg (PA), Orange County (CA) and Jefferson County (AL) on the growing list of communities buckling under the weight of their debt obligations.

If a large city like L.A. or Detroit files for bankruptcy, panic could ripple through the entire municipal bond market. Investor fear could cause the entire municipal market to seize up, similar to the credit crunch recently experienced by financial institutions.

But a prevalent option, and one that gives municipal bonds their reputation for safety, is that governments will always be able to raise taxes to fulfill their obligations.  The rise of the Tea Party seems to contradict that notion.  

The other commonly held belief about the municipal bond market, and one voiced by Mr. Warren Buffett himself, is that the federal government won't allow a major default. At the latest Berkshire Hathaway (NYSE: BRK-A) annual meeting, Buffett said, "It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they've gone to General Motors and other entities and saved them."

So who would be large enough for a bailout? The State of California certainly would be, but probably not the City of Los Angeles. So even if states are too big to fail, the scores of cities and other local governments teetering on the edge of solvency surely would not qualify.

Re-Examine Your Traditional Notions of Safety
Wall Street is always looking to punish the weakest candidates through relentless short selling or by betting on defaults. Today, companies can be destroyed in the blink of an eye if traders smell weakness. This is not meant to frighten you -- it is meant to challenge the traditional notions of which investments are safe.

The fear is that those most exposed to a crisis in the municipal bond market are those least able to withstand a meltdown. A bunch of pensioners and retirees losing their savings doesn't threaten the entire global financial system, so it may not warrant a Washington bailout. But could be a disaster for those who thought they were doing the right thing and seeking out safe investments.

So after all this, the question remains: if you are concerned about a potential municipal bond rout, how can you protect yourself?

First, check that you're not over-exposed to municipal bonds. Understand that a 1 percent historic default rate does not mean there's a 1 percent chance of default in today's volatile market. If you're invested in a fund or ETF, read the prospectus to see what kinds of bonds they hold. If it seems too risky, find another fund.  

Next, make sure your investment meets the time horizon you're investing over. If you need the money in 10 years, you can ride out the choppiness of the coming months or years and come out intact on the other side. If you need the money now, move it to something without as much credit risk.

Before you invest in anything, do some research to find the specific bonds that are best-in-class. And don't rely on the ratings agencies to do your research for you. Only buy investment-grade bonds issued by cities and states that are fiscally responsible. Don't chase yields -- there's a reason that some cities and states need to entice investors with higher yields.

And finally, if in your research you've come across  the worst-in-class, you can profit by short selling the weakest issues or you can buy put options as insurance against price declines.