Municipal bonds are still considered safe, despite some afflicting governments

Municipal bonds are still considered safe, despite some afflicting governments

Puerto Rico is drowning in $ 72 billion in debt that it can not repay. Several states – Illinois, Pennsylvania, New Jersey and Kentucky among themselves – are facing increasing financial problems, mainly due to pension plans that are not adequately funded.

These government trauma are only two years after the historic failure of Detroit, the largest municipal default ever.

Since individuals hold most of the $ 3.7 billion invested in municipal bonds – or about 70 percent, directly or through mutual funds – raises the question: if investors are worried? After all, municipal bonds have traditionally been considered as safe investments.

Municipal Bonds Still Considered Safe, Despite Some Ailing Governments

“Today, there is more stress in the egg market than it was 10 years ago, because there are higher fixed costs such as retirement pensions and health care costs, increased debt costs, and increased income “Said Lisa Washburn, managing director of the Municipal Market Analytics, a research firm based in Concord, Mass.” I am more concerned with the deterioration of credit in States with significant pension problems but are not concerned about this Any default risk at state level. ”

Overall default levels remain extremely low and no significant increase is expected. The default rate of the S & P Municipal Bond index, which follows 84,000 bonds from more than 22,000 issuers, was 0.17% in 2014, against about 0.11 in 2013.

“We expect to see a slight increase from the past in terms of bankruptcy or restructuring, but we have to put it in perspective,” said Christopher W. Alwine, head of the Vanguard Municipal Debt Group. “These are some isolated events in a very big market.”

However, the pension problem does not go away soon. Cities, counties and states will continue their struggle to find the most politically delicious and financially viable ways to sustain their finances. In some cases, governments have issued more bonds to fill the lack of retirement, which feels a bit like using a credit card to cover daily bills.

A recent analysis by the Pew Charitable Trust found that state and local pensions had a $ 1 trillion gap. Illinois’s pension system, for example, was only funded in 39 percent in 2013, according to the report and the Kentucky system was only 44 percent funded.

“Some states have great pension problems, but they also have a great deal of power to manage their expenses and increase their revenues,” said Al Medioli, head of the public finance group’s credit policy at Moody’s Investor Service. “Some local governments are having a tougher time.”

The ability to raise taxes has played an important role in maintaining the default rates of municipal bonds so low overall – and it has contributed to the perception that lien loans are generally solid investments. General bond bonds were issued by municipal governments and backed by their “full confidence, credit and tax power” and investors in those bonds were legitimated to demand a tax increase ordered by the court if this would be necessary to avoid a default . Even in the extremely rare case, when a municipality filed bankruptcy, bondholders generally recovered most or all of their money, bond analysts said.

But in Detroit’s failure, that did not happen. The general bond bond has recovered at most only 74 cents on the dollar and in some cases less, while many so-called income bondholders have not been injured. Bonds, such as those issued by a sewerage authority for a new treatment facility, are redeemed with a specific revenue stream generated by that authority. As a result, some large and small bonds and investors are avoiding issues of general bonds in favor of income bonds.

“This is the turn of what has been taught in Bonds 101,” said Marilyn Cohen, president of Envision Capital Management in El Segundo, California, which manages bond portfolios. “Everything we’ve been taught about general bond bonds, which emitters have the unlimited capacity to tax people and pay bonds, we learned it was false.”

Peter Hayes, head of the BlackRock municipal bond group, called it the emergence of a dangerous precedent. “If you look at Detroit, it was really more about politics than the law,” he added.

In Detroit’s bankruptcy, as well as with those in Stockton and San Bernardino, California, retirees have been widely seen as better than bondholders since they have received smaller reductions to their benefits, although many retirees have made concessions.

Investors are often attracted to municipal bonds, which contribute to paying public projects because of their favorable tax treatment: Individuals generally do not pay federal income tax on the interest they receive. And if you live in the state where the loan was issued, your interests may be exempt from state and local income tax.

Given the tax advantages, munis is often associated with investors in higher tax rates, but financial advisers have said they have often made sense for people in upper-middle class classes, for example, 28 percent or more.

Wherever you drop the tax hierarchy, however, what emerged from the financial crises of Puerto Rico and elsewhere are some basic lessons that repeat: Invest in only a diversified portfolio of municipal bonds and you know what you own. Financial advisers said it could be difficult to mount a diversified portfolio of individual securities without $ 500,000 to $ 750,000, although some said it could be done with a minimum of $ 250,000.

Many mutual funds offer greater diversification: for example, in most Vanguard municipal bond funds, most issuers account for less than 1 percent of total fund holdings.

But that does not mean that fund investors are fully protected. Portoric debt, for example, is about 52 percent of municipal bond funds, according to Morningstar. Exposures range from less than 1% of fund assets to almost half.

Consider raising municipal bond funds offered by Oppenheimer Funds, named after individual states that are particularly attractive to people living in such states because they do not pay taxes on three-tiered bonds: federal, state, and local.

For example, the Rochester County State Fund had about 52% of its holdings in Maryland bonds since June 30, while approximately 48% were in Puerto Rico. And the Virginia fund had nearly 40 percent of its holdings in Puerto Rican bonds, according to the Oppenheimer website.

So, how does a fund named after a state invest an overwhelming piece of its assets in another venue?

It is perfectly legal, according to the rules of the Securities and Exchange Commission, on which companies can indicate their investments. Yes, monolithic communal funds must invest 80% of their assets in the state’s designated investment. But extra-state security can be placed in the 80% bin if you pay the interest free of federal income tax and declared state tax – a bar that is cleared from US territories like Puerto Rico, Guam, and Virgin Islands.

With Puerto Rico, “due to its high performance and its tax exempt status for triple business, it has been particularly attractive to some companies and managers that run mono-state monopoly funds,” said Beth Foos, senior analyst at Morningstar. Noted that the investment universe of the monoparent fund was limited.

Puerto Rico is an unusual case. But the small island appears in so many portfolios should serve as a reminder to all municipal investors. “You need to know where you are going,” said Ann Rutledge, co-founder of the rating company R & R Consulting, “and how do you do it again.”

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