Traditionally, investors look at municipal bonds as the steady income producing component of their portfolio. These are the bonds issued by a local government or one of its agencies to finance brick and mortar type projects like schools, highways, airports, etc. A government pays back the cost of the bond and interest to the investor through taxes or other generated income. Furthermore, municipal bonds are exceptionally attractive because the interest income received by holders of municipal bonds is often excludable from gross income for federal income tax purposes under Section 103 of the Internal Revenue Code. They could also be exempt from state income tax as well, depending on your state of residency and applicable state income tax laws.
The security in these bonds is knowing what the return on investment will be and when it occurs. That’s because states, counties, and local governments or their agencies have a clear track record to determine how they will pay off the bonds when they come due. They have statistics and history that enable them to know how much money will come into their coffers and the timing. It is these factors that usually make the highly rated bonds a substantial, conservative investment.
As we have gone through the past couple of months with life turned upside down due to COVID-19, the integrity and stability of municipal bonds come into question. Unfortunately, we have seen firsthand how Coronavirus rips away the foundation of what supports a municipal bond. Let’s look at New York City as an example. Here is the biggest city in America that two months ago was chugging along fine. Business was doing well. Tourists flocked to the city. Both of those factors drove hotel and restaurant revenue, fueled Broadway, and other attractions also did well.
Then with the light of a new day, everything changed. The City That Never Sleeps did – both day and night. Everything shut down. Suddenly absent were all those fees and tax revenues that drove the New York City government. The entire stability of having the money to pay the city’s vast employment force as well as other obligations immediately dried up. The city has not defaulted on any bonds yet, but it has slowed down issuing new bonds.
The $3.8 trillion municipal bond market has reopened for new issues after shutting down amid a mass exodus of funds in March. Still, the secondary market remains weak, and spreads are widening as investors watch how Congress will deal with cities that are financially devastated. A test case comes this month when the hard-hit New York transit system issues debt. Issuers of such bonds have to deal with how local governments are going to deal with budget deficits and try to forecast how economies will bounce back.
Not since World War II has the country encountered an event that consumed the nation and made people change their lifestyle, even though that was a relatively gradual change to America. We were celebrating the New Year on January 1, 2020, without an inkling of what the future held. Every aspect of life changed, including some of the most common practices of investing. It is helpful to look at some of the historical failures of municipal bonds so that you can see that even the most reliable investments have a degree of risk.
During the 1930s, 4,770 municipals defaulted on their bond obligations. While the causes of the Great Depression are complex, the similarity to today is fundamental: cities lost considerable amounts of revenue that they banked on using. The Stock Market Crash of 1929 was the catalyst to the change in revenue as the Coronavirus is to us now.
The Washington Public Power Supply System (WPPSS), in the 1970s and 1980s, sold bonds in the 70s and 80s to finance the construction of five nuclear plants needed to accommodate increased demand. In 1983, poor management and unsatisfactory safety conditions caused the building of the plants to cost four times as much as initially estimated. In the end, WPPSS defaulted on a $2.25 billion debt.
There are other examples of cities in Alabama, California, and Pennsylvania who had such deficit issues with their budgets, that they declared bankruptcy, which undoubtedly affected bond payments. While bondholders did eventually get their due, it wasn’t happening in the timeframe they originally thought.
In conclusion, while highly rated municipal bonds are a reliable but conservative investment vehicle, even they are not a sure thing. We are in unknown times right now. It is going to take some time for the dust to settle down to see how local governments are going to finance themselves. At the time of this writing, some states are only beginning to open up, while others are still on an uncertain schedule.
More than ever, you do need to do more research and tap the brains of smartest investment advisors. If you like this then probably you will like my Special Report – “How to Recover Stock Market Losses From the COVID-19 Crisis Quickly & Safely – without liquidating your portfolio or replacing your investment advisor” and you can get it here.