Municipal Bonds Can Default

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I’ve written about buying municipal and state bonds in the past but I’ve never actually done it. When reviewing Maryland bonds, the rates just didn’t seem high enough for me (I’d looked at investing directly with the state through one of their partners and at buying bonds out in the market) so I never did it.

While I never thought about municipal bonds defaulting, I knew that it was a possibility. Certificates of deposit are backed by FDIC insurance. Treasury bonds are backed by the Federal government. If the Feds defaulted, I’d have bigger problems than losing what little I invested in those two vehicles. With municipal bonds, backed by states and counties, the default risk is very real.

Just last week, commissioners in Jefferson County in Alabama voted 4-1 to default on $3.14 billion in municipal bonds. The bonds were to fund a sewer renovation and commissions had approved a plan, back in September, that would avoid this that included $1.1 billion in concessions and a sewer rate increase of up to 8.2% over the first three years. Creditors wouldn’t agree to those concessions, the county legislature couldn’t pass a bill, and so now it appears the county will default.

While this particular default made headlines because of its size, the article goes on to discuss other defaults. Jefferson County is just the 11th this year and beat the previous record set by Orange County, California in 1994. In that default, there were $2.2 billion in debt outstanding.

{ 7 comments, please add your thoughts now! }

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7 Responses to “Municipal Bonds Can Default”

  1. Andy says:

    Harrisburg, PA tried to file for bankruptcy but the state stepped in and passed a bill making it illegal for third class cities to file for bankruptcy. Now the state is taking over. In this case, the bondholders are being protected at the expense of the taxpayers.

  2. Scott says:

    I invest in an ETF (BAB) which covers taxable Build America municipal bonds and I’m looking to buy some more, but the prices right now are too high. The fund currently yields 5.33% and I consider it low risk. Are large numbers of states, cities, etc. really going to default on their debts? I was hoping this default in Alabama would spook people into selling to drive down the prices.

    • Evan says:

      Alternatively couldn’t the Jefferson County provide an example for other counties that want to press the reset button? Sort of a “if they can do it at 3.2 Bil why can’t I do it at my measly 500Mil?”

  3. Dave says:

    The Jefferson county story is definitely worth reading into — if only as a cautionary tale. Take a look at this very thorough rundown of the whole slimy affair by Matt Taibi,

    The corruption involved on every level of that mess is appalling.

  4. uclalien says:

    A few comments:

    1) While Orange County did declare bankruptcy, it never missed one debt service payment.

    From The Bond Buyer:

    “But it’s worth remembering how much bondholders lost during the 18-month case: not a dime.

    “With one exception, Orange County bondholders continued to receive full payments throughout and after the Chapter 9 proceeding. The outlier was $2 billion of short-term obligations, where principal repayment was extended by a year and topped with a higher interest rate as compensation.”

    It should also be noted that the County Treasurer pled guilty to 6 felonies that, in large part, caused the bankruptcy.

    2) Coincidentally, a few minutes before I came across this blog post, I was reading a newsletter that discussed the Jefferson County bankruptcy. It said the following:

    “The Jefferson County problems stemmed from an unusual combination of huge cost overruns for a relatively small revenue base, ill-advised swaps, a degree of fraud and a political impasse over proposals to resolve the crisis. In the view of most credit analysts, this is a one-off situation, not an indication of systemic problems for the muni market. For most state and local governments, measures of fiscal health are improving, not deteriorating.”

    3) So although municipal bankruptcies can and do occur:
    a) It isn’t guaranteed that investors will lose anything.
    b) They are the result from a “perfect storm” of extenuating circumstances and/or fraudulent activities (as in Orange County), making them very rare.

    In other words, the returns on municipal bonds are, in general, extremely safe when compared to nearly any other investment type.

    Let’s also keep in mind that the real (inflation adjusted) return on Treasuries has been at or below zero for a few years now. And the real return on CDs backed by the FDIC have been running well behind inflation for the past couple years. In other words, you presently lose money by investing in CDs.

  5. Frank says:

    Jefferson County isn’t “a trigger for anything further,” said Joseph Pangallozzi, a credit analyst at New York-based BlackRock Inc., which manages $95.6 billion of municipals, on a conference call last week. “This is not the beginning of a rush to bankruptcy.”

    This year, municipal defaults through September totaled only $949 million, compared with $2.9 billion in the first nine months of 2010, according to the Distressed Debt Securities Newsletter, published by Miami Lakes, Fla.-based Income Securities Advisors Inc.

  6. debbie says:

    it would be helpful to know what the ratings of these bonds were.

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