The once staid municipal bond market has received a lot of negative press lately. The states face unprecedented budget shortfalls. Stimulus money awarded to states during the financial crisis is starting to dry up. The Great Recession of 2008 pushed tax revenues down significantly. Politicians are loathe to cut expenses. State pension obligations look especially onerous after a decade of poor U.S. equity returns. Talk of Congress possibly changing the rules to allow states to file for bankruptcywas cited in a NY Times article earlier this week.
What does all of this mean for municipal bond investors?
It means a couple of things. First, it probably isn’t a great time to own a municipal bond index or mutual fund. These types of funds will very likely have significant exposure to states that are not in good shape. Why? Because the states that issue the most debt are usually in the worst financial shape, and more debt likely means a higher representation in a bond index or mutual fund!
Second, it means that performing credit analysis on each and every bond issue in your portfolio has become more important than ever. The municipal bond market is not a homogenous market. There are good states and there are bad states. Good states are in good fiscal shape. Good states are growing and attracting businesses. Bad states are in terrible fiscal shape. Bad states are typically not growing, and have heavy pension costs, and cash flow has been crushed by the recession or because of the downfall of a once- important industry. Though there are exceptions (e.g. it is possible to find good credits within bad states) Farr, Miller & Washington focuses most of its attention and credit analysis on bonds in “good” states. Bonds that are used to fund essential services (e.g. water, sewer, infrastructure spending, healthcare, education, etc.) are typically favored. Detailed credit analysis is then performed on each issue. Debt levels, cash flow levels, interest coverage ratios, specific project details, and local demographic and political trends are all examined.