Many investors considered municipal debt a very safe form of investment, second to only the U.S. treasuries. It was also assumed that municipalities have the authority to increase taxes and generate more revenue to meet their obligations. However, prominent bankruptcies in the U.S., including those in Stockton and Detroit, have demonstrated the other side of the story.
It is important to understand the intricacies of the municipal debt instruments and revenue streams that backed these bonds.
As a result, in this article, we aim to take a closer look at the ways investors can protect their assets and capitalize on the municipal markets by focusing on various provisions of a municipal debt issue.
Unfunded Liabilities in the U.S.
While the Treasury rates have been so favorable for local and state-level debt refundings, they are also causing these local and state-level entities to think hard about their unfunded pension liabilities. Let us consider the case of California.
The majority of local governments in California go through CalPERS (the California Public Employee Retirement System) for their retiree pension system, making CalPERS the largest U.S. pension fund. Each local government puts money into its CalPERS portfolio to meet its retiree pension obligations. In turn, CalPERS assigns an assumed return on that portfolio of 7.5% per year, also known as the discount rate. If investments in CalPERS’s portfolio don’t return 7.5%, then the local governments have to come up with the difference to meet their monthly retirement obligations. This has been the challenge, in the low-rate environment, for a majority of the local governments in the United States.
This is how grave the situation was for the largest U.S. pension fund. For the fiscal year ended June 30, 2016, CalPERS reported a mere net return of 0.61% on its investment portfolio. Obviously, CalPERS had difficulties churning out returns in line with its assumed discount rate of 7.5%. As a result, investors holding debt securities from the affected municipalities are seeking strategies to tackle this issue.
Keep our Municipal Bond Glossary handy to get familiarize with the various terminologies used by the market participants.
General Obligation Muni Bonds in Difficult Times
For any municipal debt investor, it’s crucial to read and understand the official statement of any municipal debt. For example, investors have often assumed that all general obligation (GO) debt is backed by the “full faith and credit” of the issuer, as well as the “taxing power.” Several bankruptcy cases made it apparent that this is not always true.
Two commonly adopted ways to increase tax revenue are:
- Unlimited-tax general obligation bonds (UTGOs): Voter approval (typically around 60%) is required to issue such bonds; essentially, these bonds warrant an additional levy to be placed on properties to generate funds for debt service. Ultimately, this increases the issuer’s property tax bill.
- Limited-tax general obligation bonds (LTGOs): These bonds are issued with a general fund pledge to meet the debt service requirements. Since no new property taxes are proposed, these issues can commence with legislative body approval (e.g., council approval) instead of voter approval.
Furthermore, GO debt can have secured or unsecured claims post–bankruptcy proceedings. The Capital Improvement tax bond issued by Chicago Public Schools (CPS) had legal complications for determining the pecking order of investment claims. The recent issuance by CPS garnered an A rating by Fitch, despite having its GO debt rated B-, with a negative outlook.
In its assessment, Fitch suggested that “the pledged revenues meet the definition of ‘special revenues’ under the U.S. Bankruptcy Code and therefore, bondholders are legally insulated from any operating risk of the board."
Investors must carefully analyze the official statement of muni bonds to understand the revenue pledges. Investors must also understand the sustainability of these revenue sources in the middle of an economic downturn.
Read up on due diligence for muni bonds to gain a better understanding of the regulatory framework.
Pay Heed to Special Provisions
Now let’s take a look at various ways muni investors can protect their investments during uncertain times.
Bond insurance: For any bond issuance, the ability to honor the repayments and investor appetite for that bond is taken into consideration by rating agencies. Muni bond insurance is a form of a financial guaranty by an insurance company that insures the principal and interest payments in the event of default.
Call option: A municipal debt investor should always consider reinvestment risk – i.e., the risk of municipal bonds being called by the issuer and having to look for an alternative investment in a short period of time.
For example, in a low-rate environment issuers will always seek to refinance their expensive debt (higher coupons) at low coupon rates. Investors must always have a proper strategy to combat this risk by either having a mix of callable and noncallable debt, constructing bond ladders, or selecting alternative investments that will help them meet their investment objectives. The following provisions for callable bonds should be carefully understood by an investor.
- Sinking fund provision: It allows an issuer to set aside capital for bond buyback at a future time at a predetermined rate. This is a good way for issuers to mitigate interest rate risk; however, bondholders typically demand higher yield for this risk.
- Pre-refunding option: It allows issuers to issue new debt to refund an old issue.
- Non-callable period: For callable bonds, there is a set timeframe in which these bonds can’t be called by the issuer, giving investors some certainty and peace of mind regarding their coupon payments.
Bond Ratings: Investors must keep an active eye on their investments and stay cognizant of any rating changes. Rating agencies often do their surveillance calls or annual reviews for all municipalities and give their outlook for their respective debts. Anyone invested in an issue from a bankrupt or near-bankrupt issuer should keep the following things in mind:
- Pecking order: In the case of the Chapter 9 bankruptcy of a municipality, there is a pecking order of creditors and investors in terms of who gets paid first. This is determined by the revenue pledges and the structure of the debt.
- Insured vs. uninsured bond issuances: As mentioned above, a muni debt issuer can have both insured and uninsured issues. Make sure to ascertain that investment in uninsured muni debt is the right option.
- Rights of bondholders post-bankruptcy: Investors must familiarize themselves with the bond indentures to know their rights post-Chapter 9 proceedings.
As municipal debt markets are evolving, investors must understand and analyze the intricacies of their own holdings. The recent Chapter 9 proceedings at various municipalities were certainly an eye-opener for many fund managers and investors; it showed that the payment pecking order for GO muni debt is not homogeneous all across the U.S.
In addition, muni investors need to be aware of any special provisions for bonds in which they plan to invest. For instance, it is always wise to be aware of and scrutinize call provisions, expected benefits from credit enhancement options, and legal rights during possible bankruptcy proceedings.
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