High yield bonds, often known as junk bonds, have been very popular investments since the financial ...
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The State of Muni Bonds
01/16/2013 9:45 am EST
As we enter 2013, it's a good time to see where munis stand after avoiding most of the threats posed during fiscal cliff negotiations, notes Marilyn Cohen of Bond Smart Investor.
The sacred cow avoided being gored. President Obama's desire to limit the income tax deduction on municipal debt to 28% appears to have been shelved-for now.
Still, the President has four years in which to chip away at the tax benefits munis provide investors. We know his intentions and we know that he is no quitter. Still, our tax-free munis seem to have emerged unscathed from the tax changes just enacted.
As you read this, check to be sure none of the names mentioned here appear in your own bond portfolio. If you're watching one or more holdings that appear to be in trouble, take advantage of the MSRB's Web site, EMMA (www.EMMA. MSRB.org). This site identifies your particular bonds suffering material events.
Such events seldom foretell good news for bondholders. The problems that Material Events usually foretell are significant-like fraud, criminal charges against city officials, and credit downgrades. If you discover such material events on EMMA, consider heading for the exits.
Pennsylvania Pension Payouts
A large number of Pennsylvania municipalities are showing an alarming disregard for statutory pension payouts to public employees-in the employees' favor.
Certainly our city employees are valued and appreciated. Police and firefighters deserve their well-earned pensions. But not to the point where their payment forces the very cities they worked for into bankruptcy.
Allentown, PA is such a city. For some time, Allentown has been grossly overpaying its retired city employees' benefits their contracts say they are not entitled to. Greg Scheirer, a retired 26-year veteran of the Allentown Fire Department, received an annual pension benefit of $99,289-more than 150% of what the Pennsylvania state law says was actually owed. As a result of this and other unnecessary (and illegal) generosity, Allentown must now lease its water system in order to pay for these hugely inflated pension costs.
Allentown isn't the only case. Indeed, Bloomberg News reports that 26% of all Pennsylvania municipalities have policies of paying pensions well beyond statutory guidelines. This has added an extra $1 billion in unfunded pension liabilities, boosting the unfunded total to $8.5 billion. Pennsylvania taxpayers will have to foot that bill eventually.
Why would an already cash-strapped city do such a stupid thing? The answer lies in form over substance-another way of saying the elected officials kicked the can down the road.
Rather than give city employees a raise that immediately increases the city's budget deficit, why not just promise them a greater pension benefit sometime in the future? The pension benefits have such a large unfunded component that a little more unplanned expenditure won't make much difference anyway.
Now we see these chickens have come home to roost. However, apparently Pennsylvania bond investors agree with this strategy. They demanded just 0.28 percentage points of extra yield to own the state's and its municipalities' debt.|pagebreak|
Puerto Rico, Still in Hot Water
Moody's cut the Commonwealth of Puerto Rico's credit rating to Baa3-just one step above speculative grade. Perhaps it was because its debt load is ten times that of the US average, and has the nation's weakest pension system with less than 7% of all payment obligations actually funded.
Many of our readers own Puerto Rico bonds since they are tax-exempt in all states. As Puerto Rico prepares to issue more debt, we see yields climbing even further as bond prices fall. Yet, we still see the market with a desire to absorb its debt. However-and this is a biggie-Puerto Rico is hovering close to a junk bond rating.
Indeed, Moody's has already reduced the rating of one $5 billion tranche of Puerto Rico debt to junk. Another downgrade into the junkyard would be a big problem. Many state-specific mutual funds hold Puerto Rico bonds. A good number of these have charters prohibiting them from owning junk bonds.
See the problem? Another rating downgrade would flood the market with Puerto Rico bonds from these funds that simply have no choice but to sell them. Certainly, these fund managers are smart people. One would think they have already foreseen this possibility and reduced their Puerto Rico holdings. Still, in this business there are always those who wait for the actual event to take place before taking action.
JPMorgan Chase Rigged Municipal Bond Bids
This much-publicized case has been settled for $44.6 million without JPMorgan Chase admitting to any wrongdoing. You may recall bond issuers filed the suit when it was discovered that JPMorgan Chase (along with some other banks) restrained, suppressed, and eliminated competition for municipal derivatives.
CA Redevelopment Agencies Ripple Effect
When California Governor Brown dissolved the state's Redevelopment Agencies to plug $1 billion in budget deficits, the law of unintended consequences took hold. Many small cities depended on that money to finance badly needed infrastructure projects.
The city of Farmersville was forced to scrub a fire station. Now its firefighters sleep in the city council chambers, share a public bathroom, and cook meals in the city hall break room. San Diego, Hemet, and (of course) San Bernardino have also felt the effects of Governor Brown's decision.
However, if you currently hold California redevelopment securities, things may not be so bad for you. According to Barclays, yields on California municipal debt remain at a 47-year low. California bonds earned 8.4% last year, compared to 7% for the $3.7 trillion national market for local debt.
San Jose is a good example of this. The city's redevelopment bonds maturing 2035 recently traded at an average yield of 5.79%-about 3.1 percentage points over similar maturing Treasuries.
Precarious Pension Bonds
Read this carefully if you own pension bonds. The very fact that a state or local government had to issue pension bonds raises a red flag. It says the issuing entity has failed to find a long-term solution to their pension under funding. The existence of pension bonds raises the potential of default and won't likely improve the issuer's credit rating.
Simply put, here's what issuing a pension bond does: It turns what was once merely an unfunded promise to pay the pension fund into a legal debt. The amount of money owed stays the same. Only now, if the state or municipality fails to pay the bond service on time, it will default. Further, it increases the amount of money that will actually be paid due to bond interest accumulating.
If you own pension bonds, you must ask yourself if they make sense for the issuer. If not, then get out.
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