I spoke this week at an NYC municipal bond conference where the theme of the day was, “What can’t go on forever, won’t.” What can’t go on forever, in this case, are the promises states and, especially, municipalities have made to pay employees, retirees, vendors and bondholders well into the future for goods and services delivered in the past. As headline controversies from New York to Florida to California and back around to Wisconsin suggest, not all of those promises will be kept in the way that parties to the bargain may have expected.
The 1983 default of $2.25 billion of Washington Public Power Supply System (WPPSS) municipal bonds turned muni bond credit research into a real Wall Street job and helped rescue me from academia. What I learned from that still-largest default of municipal debt is that investors should be extremely wary of investing in projects and entities that don’t make economic sense even if, as in WPPSS’ case, firm agreements apparently say they’ll get paid anyway.
When courts got ahold of agreements that would have vastly raised electric bills in the Northwest to pay for electric generating plants that would never be built, the courts vacated those contracts. I’m not qualified to comment on the legal decision, but it’s likely they would never have reviewed the contracts if the plants had been completed and the juice had flowed into folks’ light bulbs.
As budgets tighten, investors, firefighters and pensioners all need to ask the same question, “Am I party to a contract that makes economic sense to honor?” For bondholders, experience and logic say, “Yes, probably.” The mere fact that we’re still talking about WPPSS almost 30 years later—or that people who can’t name a second California city with a population of 120,000 somehow know that Vallejo is bankrupt—tells me that municipal defaults and bankruptcies are highly exceptional.
Will more contracts go to court? That remains to be seen. But if courts are eventually asked to sort out claims on inadequate municipal revenues, I want my claim
1) defined and limited (unlike heathcare benefits)
2) backed by a revenue stream I’ve carefully analyzed
3) from someone who will need to borrow again
Are municipal employees, retirees and vendors in a position to scrutinize these factors? In practical terms, not generally. On the whole, I’d rather be a bondholder.
A portion of a municipal bond fund’s distributions may be subject to tax and may increase taxes for investors subject to the Alternative Minimum Tax (AMT). Capital gains distributions are taxable as capital gains.
Bonds are exposed to credit and interest rate risks (when rates rise, bond/fund prices generally fall).