Two things have been obvious these past few months  1) the press has succeeded in making clear the mess of state and local government budgets, and 2) prices of municipal bonds (the notes behind state & local government loans) have really stumbled.  A trusted friend and industry insider recently told me that although these municipal bonds are priced reasonably well right now, headline news could make things tough for a while yet. This combination leads me to ponder some questions about the real state of affairs.

Just how close are we to muni defaults? Like most households, state and local governments have fixed debt obligations that make up a portion of their overall budget.  Fortunately, these debt obligations represent just a portion of total discretionary income, or revenue. Unfortunately, like most families, local governments quickly commit the remaining percentage of their income/revenue with other important issues – families with things like food, clothing, entertainment and travel, and governments with transportation, police, social services and the like. When we get used to spending at least as much income as comes in, there are hard decisions and changes to make when income suddenly falls. What to cut – vacation, education, dining out with the family? Clearly there are difficult choices to make. Assuming for a second, though, that fixed debt service is less than 25 – 35% of income, I can honestly say that as tough as things may be, bankruptcy or default on loans is not where people begin making cuts. Likewise are the decisions of the states. Let’s take, for example, the State of California. California should take in at least $85 billion in revenue. The total debt service of their bonds is about $8b. In their case, they have 10 times more revenue than necessary to take care of their debt obligations. Like a family with a substantial drop in income, do they have tough decisions to make? Absolutely! Is defaulting on their bonds particularly likely? Not especially. As one California muni bond manager said, “I’m far more worried about riots in the streets of California from cuts in social programs than I am about defaults on bonds.”

Income control Often overlooked is the control that state and local governments have on their income or revenue. Just last week the State of Illinois raised taxes 67%. Wouldn’t it be great if we, as families, when we find ourselves in tight financial predicaments could simply flip the switch and increase our income? If the states already have a reasonable amount of free cash flow to meet debt obligation and, in addition, have the ability to quickly raise revenue, then the fear of defaults seem to me even less significant.

The unthinkable A municipality in bankruptcy — Partly for familial reasons I am partial to Orange County California. In 1994 they made big news by going bankrupt. A series of bad investments and risky portfolio decisions by the county caused a multibillion dollar loss that lead to their bankruptcy. Without doubt the headlines were ugly. The rush of investors selling these bonds caused the prices of the bonds to fall sharply. Interestingly, though, over time not only was 100% of the principal paid on the bonds / loans, but for the few missed interest payments, interest on interest was paid to make all bondholders whole. Surely it was a tough time to hold bonds in Orange County. Yet ZERO was lost for those that held. And for those that held in a diversified portfolio where, perhaps Orange County bonds represented 2% or less, it was obviously a non-issue in the grand scheme.

In summary: Headlines are just that I don’t want to minimize the drop in revenue that state and local governments have experienced nor the difficult decisions they will continue to face. I simply want to provide some context. The portion of revenue required to service municipal bonds represents but a fraction of total revenue. These same governmental bodies also have taxing authority and can quickly raise revenue as we’ve just witnessed in Illinois. Finally, even when things go truly awry and municipalities default, it may not necessarily be catastrophic for investors and especially for those who are appropriately diversified. Municipal bonds may face ongoing pressure, certainly in the short term, from headlines. Without question, though, they should continue to play an important role in many of my clients’ allocation as we build strong, healthy, well diversified portfolios.