For nearly all of its history, municipal bonds have been regarded as one of the safest investments that one could make. After all, general obligation government bonds are backed by the taxing power of a given jurisdiction. If you buy a United States bond, your likelihood of being paid interest and later your principal is based on the ability of the United States government to tax over 300 million. If you buy a bond issued, say, by the state of Texas, your likelihood of being repaid is determined by the Texas state government’s ability to tax 27 million people.
The same principle extends to cities and counties that choose to issue general obligation bonds. You are forward a certain amount of principal (often in $1,000 or $10,000 increments) in exchange for a promise to receive interest (usually paid semi-annually) and certain tax relief plus a return of principal (usually at a stated year in advance, though municipality’s typically reserve the right to repay sooner) that is backed by nothing but the taxing power of the jurisdiction.
What I find concerning is that, at the local level, technological advances have been so significant that affluent households and businesses can better sidestep municipal efforts to collect additional revenues. If a municipality, facing a tax crunch, elects to raise taxes, it can either engage in regressive taxation by adding sales taxes that are paid by the working poor, which is often politically and morally assailable, or they can attempt to raise taxes on the rich. My argument is that, because it is now easier for businesses to reincorporate and for businesses to redomicile, tax increases no longer possess the same curative powers.
This theory has received limited testing—the general trend of the past twenty or thirty years has been in favor of lowering taxes while this simultaneous increase in the mobility of capital has occurred—and that is why it is an unappreciated risk.
Also, paradoxically, when I review municipal bond offerings, many of them only yield 3-4%. At that point, why not just purchase a 2.8% yielding U.S. Treasury? On the other hand, the municipal bond offerings that pay interest over 7% involve real tests to solvency in that they are located in communities with deteriorating tax bases and heaping piles of accumulated debt, often due to colossal pension obligations (note: I do not blame the retired firefighters and police officers for this boondoggle. They received these pension claims as part of the compensation they were promised. I blame local governments that touted their support for firefighters and police officers by promising $60,000+ pensions, not sticking around to bear the consequences of these decisions forty years later.)
I question the ability, in an era with ever-lowering barriers to capital flight as a response to municipal tax hikes, of any indebted municipality to remain solvent for a period of 30+ years from the point it begins taking on debt bearing a 7% interest rate or higher.
In the event of default, there is no remedy for the general obligation municipal bondholder. The only “stick” in the transaction is that, if a municipality does not make payment, the interest rate on future obligations would be extreme (if they are even able to borrow at all).
In the event that a municipality declares bankruptcy, bondholders are treated as general unsecured creditors with claims subordinate to, say, wages owed municipal employees or the pension obligations due to retired employees covered by the municipality.
If I had to invest in municipal bonds, I would look to robust cities and counties in Texas and Florida where there is population growth, rising industry, and reasonably current-existing obligations on the books. California and New York can be compelling, if you have the skill to identify the unusual municipality that is not saddled with a meddlesome amount of debt. In these instances, it is possible to capture 3.5% to 4.8% interest rates with a likelihood of being repaid that matches the traditional understanding of a municipal bond’s safety.
But generally speaking, we are living in a world where the risk profile of municipal bonds have heightened, but the world has not yet caught on. This is because: (1) taxes have not risen substantially, spurring on capital flight and the other natural consequences; (2) the prime interest rate has generally been low, meaning that municipalities haven’t endured extreme interest expenses that would encourage bankruptcy; and (3) many of the pensioners that would exacerbate a municipal crisis are still working and have not yet shifted into collecting on the outstanding claims.
Generally speaking, intelligent investors look for “risk-adjusted” returns. If they accept low returns, hopefully the investment is really safe. As the likelihood of safety diminishes, the potential for outsized gains should likewise rise. The risk premium for municipal bond investors right now, generally speaking, is not in the area of what I would consider an intelligent investment. Well chosen stocks and U.S. Treasury investments, or corporate bond investments tied to some type of collateral, can fill the void left by the receding attractiveness in the municipal sector.
Originally posted 2018-01-01 01:20:32.