Muni bond threat more manufactured than real

  • Article by: ERIC WIEFFERING , Star Tribune
  • Updated: February 19, 2011 - 10:11 PM

Not all municipal bonds are created equal.

Taxpayers and bond investors alike should keep this simple mantra in mind as they try to navigate the confusion and panic gripping what has traditionally been marketed as the safest and most secure of investments.

There are many good reasons not to buy municipal bonds these days, but the one that has the least merit is the notion that cities and states are about to welsh on billions of dollars' worth of borrowings.

The specter of a municipal meltdown took wing in December, when a noted analyst who'd made a prescient call on the subprime crisis told "60 Minutes" that between 50 and 100 cities would default on bonds worth hundreds of billions of dollars in 2011.

Intuitively, her argument makes sense. If a country like Greece can nearly default on its debt, why can't New Jersey, Illinois, California or any other state grappling with yawning budget gaps and soaring pension and benefit liabilities?

But this is another instance of logical assumptions producing incorrect conclusions.

There will be municipal bond defaults in 2011, but there will not be widespread municipal debt defaults by cities and states in 2011.

If you're confused, reread the first sentence of this column, then follow along on a tour of two Minnesota projects built with the assistance of municipal bond issues.

One municipal bond sale, for $1.15 million in 1999, helped finance a now-defunct charter school in Northfield. The second bond sale, for $5.4 million in 2007, went to a bankrupt, but still operating, ethanol plant on the outskirts of Fergus Falls.

The debt for each was tax-exempt. The bonds for each project were snapped up by both individual investors and large bond mutual funds like Oppenheimer's Rochester National Municipals ("For bold investors seeking high tax-free yields").

The difference between the two bonds only becomes apparent to the casual observer when both projects go into default. Ethanol plant bondholders continue to receive regular payments because they own general obligation (GO) municipal bonds, which obligate taxpayers across Otter Tail County to step in if the project's developers cannot make their payments.

Charter school bondholders are not so fortunate. Though the city of Northfield used its tax-exempt bonding authority to sell the bonds, it did not pledge its taxing authority to secure them. Instead, the debt was secured by revenue from the school itself.

The school closed, and the revenue stream evaporated, after the local school board withdrew its sponsorship of the charter school in 2006. The trustee for the bonds, U.S. Bank, has been working with a receiver to sell the building to recover some money for bondholders. A bank spokesman declined to comment on those efforts.

The bad news, especially for investors in bond mutual funds: You are far more likely to own municipal revenue bonds, which have higher default rates and lower recovery rates than general obligation bonds.

The safest revenue bonds tend to be issued on behalf of colleges and hospitals. More prone to default are tax-exempt bonds issued as subsidies to privately developed projects, such as tax increment district bonds, or bonds backed by revenue from a hotel or a parking ramp. Even so, the historic default rate for non-GO revenue bonds has been less than 1 percent.

Still, many municipal bond fund investors have been alarmed to discover that a high percentage of the municipal bonds in their "safe" mutual fund are unrated or, in some cases, not worth the dirt that -- literally -- backs them.

In Florida, an estimated $2.5 billion worth of "dirt" bonds issued by community development districts to finance construction of streets, water pipes and other infrastructure for new subdivisions are in default. About 15 percent of the assets in Rochester National Municipals are from Florida, including tens of millions' worth of community development bonds.

In other words, junk bonds masquerading as municipals.

Most municipal GO bonds are issued for public infrastructure projects, such as highways, bridges and sewer lines. The good news for both bond investors and taxpayers is that defaults on GO bonds are relatively rare. A 2009 report by Moody's, for example, found only three GO defaults in 39 years.

While budget shortfalls have put states under immediate and severe financial pressure, state general obligation indebtedness as a percentage of economic output remains relatively low. Minnesota ranks 30th in terms of debt as a percentage of gross state domestic product.

For a city or state to default on its GO debt, it would essentially have to argue that it has exhausted its ability to tax residents.

State legislatures may have lost the will to raise taxes, but they don't lack the way to do so. That's one reason why every state that issues GO debt -- even the most financially fragile ones such as Illinois, California and New Jersey -- still carry some flavor of an A rating.

ericw@startribune.com • 612-673-1736

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