As everyone probably knows by now, San Bernardino just voted to file for bankruptcy protection. This is the third California city to file bankruptcy this year. We wanted to quickly address this issue as it affects investment portfolios. First, a little background is in order. Pardon the quick recitation of statistics, but I think it’s important to see the landscape.
The bond market is huge – by far the largest headcount of all investment markets. There are 1.1 million individual municipal bonds outstanding. In contrast, there are only 400,000 corporate bonds outstanding, and only 4,488 (give or take) stocks listed in the U.S. The entire municipal bond market is valued at $3.7 trillion. This is a huge marketplace.
Beyond the sheer difference in size is the difference in substance. In a sense, each bond is different from other bonds in a way that stocks are not. When a company sells common stock, it is largely the same as the common stock already sold. My shares of IBM, if they were issued today, are the same as your shares of IBM issued 5 years ago. This is not the case with bonds. If Los Angeles issued some bonds last year, they would have specified the terms, conditions, and interest rate of those bonds at that time. If Los Angeles issues more bonds today, they can specify completely different terms, conditions and interest rates today. It’s whatever the market will accept. The point is that bonds from the same city are NOT all the same.
Given the differences between bonds from the same city, let alone the differences between bonds issued by different cities, the bond market is vastly more complicated, in addition to being much larger, than the stock market. This actually is a good thing. Each bond will stand on its own depending on the terms, conditions, rates and collectability of that particular bond. Depending on those terms, the various bonds issued by a city could very easily be treated differently in a bankruptcy. It is important, therefore, to assess the underlying strength of each bond.
While the overall municipal bond market could on any given day reflect the enthusiasm or pessimism for municipal bonds in general, there is no “contagion” that creeps from one municipal bond to all others. We saw this in the early stages of our last major market meltdown (2008-09) when municipal bonds as a category lost approximately 15% of their value in one quarter, only to bounce back as a category within a quarter. That was simply market psychology at play – there is volatility in the bond market, as there is in the stock market. There were some individual bonds that failed, but no contagion that decimated all bonds or even large numbers of bonds.
In terms of municipal bankruptcies, background is also important. There have been 7 municipal bankruptcies this year. There were 13 last year. Over the last 32 years (since 1980), there have been 268, which is an average of 8 per year. In this context, the bankruptcy filings we’re seeing today don’t seem so outlandish or scary. Municipal bankruptcies are part of the landscape. What makes them worrisome is that they tend to come in bunches. We really don’t see 8 per year every year. There are years with none, and then there are years with 11. When they happen together, they receive much more press coverage and can create the appearance of a landslide. That is not happening.
The reason we see groupings of bankruptcy filings is because the underlying circumstances which cause a default in once city can often exist in another. In today’s environment, we’re seeing the impact of spending more than the revenue being collected. Many cities have done this, but not all cities. Of the cities that have, many are correcting the problem, but some are not. Cities which have overspent are on different glide paths to soft or hard landings. But even a hard landing won’t affect all municipal bonds the same.
Municipal bonds depend on different sources of repayment. Some are general obligation bonds, which depend on the general revenue collected by the city. Others are specifically tied to a project with a specific revenue stream (revenue bonds). If a city files bankruptcy, its general obligation bonds may be at risk to some degree. Fortunately, this bankruptcy doesn’t necessarily impact the bonds of a given revenue project. The city filing bankruptcy cannot just take revenue away from a project to meets its own obligations. The revenue from a project that is contractually tied to revenue bonds that were issued for that project is protected. In such a case, we’d have to look at the underlying strength of the project to determine the strength of those project revenue bonds.
Each municipal bond has to be reviewed in light of the specifics of its repayment source – whether it’s general or project specific. Even within the geographic confines of any given city, that city’s bonds need not all be treated the same way. Some may do just fine while others will be hit hard in a bankruptcy.
We are nowhere near having a legitimate reason to panic. Furthermore, these municipal bankruptcies are not happening in a vacuum or even by complete surprise. It has been common knowledge for several years now that some cities were financially over committed. There are literally thousands of bond analysts who have been studying these municipalities, revenue projects, utility companies, development agencies, etc. to determine which are likely to face problems and which will escape unscathed from the general economic doldrums in which we find ourselves.
The price of bonds which are in trouble have largely already deteriorated to reflect perceived problems. The only thing that would significantly impact the price of any given bond today is “new” information, and the longer the bonds have been studied, the less likely there is “new” information which hasn’t already been uncovered.
Is it possible for something to slip between the cracks? Yes, but this won’t be systemic, endemic or contagious. The municipal bond market will continue to function much as it has in the past. Bonds will be issued, interest will be paid, bonds will mature and be paid off, and some bonds will default. It has always happened, and always will. But this is NOT cause to panic or abandon municipal bonds wholescale.
Remember, also, that for every bond which is sold in a panic, there is a buyer, and it is very likely that the buyer is going to make a lot of money from the transaction. To use the example of 2008/09 I cited earlier, when municipal bonds as a category sold off by 15% due to panic, the buyers of those bonds made a 15% profit (at least) when bonds as a category regained their value. It was the sellers who sold in a panic that lost money. Had they ridden out the storm, they wouldn’t have lost anything.
This brings me to specific recommendations for portfolio management. It’s agreed we’re not going to do anything across the board, so to speak, but that doesn’t mean we shouldn’t assess each bond individually – whether municipal, federal or corporate – and each bond fund individually. Every portfolio’s holding of bonds should be put through an “X-Ray” so to speak. The bones, cartilage, sinews, tendons, and everything else about them should be reviewed with regard to the quality of the bond and its specific prospects going forward in our new environment. That may seem a simple prescription, but too many investors assume bonds – all bonds – are “safe”, and they go to sleep on their portfolios. That’s the worst thing that should be done, but it’s the common thing.