Enter Bad news makes good headlines, or so it seems. The onslaught of alarmist media reports about the potential for widespread municipal defaults has subsided, but some investors harbor a lingering impression of municipal bonds that tends to overstate their risk. High profile defaults, such as Jefferson County in Alabama, seem to bolster the impression. As with any investment, the details are key. In reality, very few states and municipalities are on the verge of default. Some, like Idaho, are actually doing relatively well, and offer proof that while the near-term U.S. economic outlook may not generate a lot of positive news, municipal markets continue to offer attractive investment opportunities.

Here we examine the health of Idaho and its municipal bonds in the context of the U.S. market as a whole, in order to separate the facts from the hype. What we find is that Idaho’s staunch fiscal conservatism is serving its economy well in trying times, and that for Idaho resident investors, the tax-exempt returns from high-quality Idaho bond issues offer a relatively low-volatility way to take advantage of a bright spot in the muni market.

Market Overview

Relatively low volatility, and steady, tax-free returns have historically been the hallmarks of high-grade municipal bond investing. However, after the 2008 financial crisis, the municipal bond market suffered losses as non-traditional muni bond investors liquidated their positions. The status quo was further threatened by dire predictions of widespread muni defaults, and traditional investors defected in droves. At the end of 2010, municipal bond funds shrank by more than $9 billion over a period of about six weeks,1 a signal from investors that their long-term relationship with muni bonds had deteriorated into the fickle affections of an on-again, off-again affair.

By the latter part of 2011, state revenues across the U.S. began to stabilize. Yet, state and local governments still face the challenge of how to replace stimulus dollars in their fiscal budgets. The American Recovery and Reinvestment Act of 2009 (ARRA), passed by Congress on February 17, 2009, made available $787 billion ($142 billion of which went to states and local governments) of federal government stimulus to spur economic activity and soften the impact of falling tax revenues. Now that ARRA funds have been depleted and no additional stimulus dollars are on the horizon, states are scrambling to fill holes in their budgets. And the holes are sizeable: during the 2010 and 2011 fiscal years, stimulus funds comprised 18% and 14% of state budgets, respectively.2 Bridging that gap necessitates cutting expenditures, raising taxes, or some combination of the two.

The encouraging news for municipal bond investors is that many state and local governments are seizing upon these grim fiscal situations as opportunities to repair lingering structural deficits. With the electorate closely guarding what’s left of its recession-hit household budgets, governments have not reliably been able to fall back on tax increases requiring voter approval (with the exceptions of New York and California). As a result, some are undertaking long overdue policy revisions, such as pension reform, and are renegotiating public sector labor contracts. Indeed, bound by mandates to balance their budgets and prioritize debt service, a good number of state and local governments are meeting their budgetary challenges, albeit involuntarily, by executing difficult and unpopular revisions.

Clearly, some states are experiencing more stress than others. While California and New Jersey continue to struggle under the weight of mounting debt, the Gem State of Idaho has emerged as a diamond in the rough. Admittedly, Idaho is not immune to the pressures of the global economic downturn and the prolonged effects of the U.S. recession, but the state’s culture of staunch fiscal conservatism helped to stem its budgetary distress. Heading into a financial crisis of epidemic proportions is much less traumatic when one starts from a position of fiscal well- being, as was the case in Idaho leading up to 2008.

How realistic is the scenario of mass bankruptcies?

State and local government credit downgrades continue to outnumber upgrades across the U.S. This trend is likely to continue into the near-term, as economic growth remains sluggish and property values remain depressed. Moody’s researchers downplay the risk of any substantial uptick in defaults, however.3

In fact, the number of municipal bankruptcy filings has declined. Five municipal entities sought protection in 2010 compared with 10 in 2009. 4 There have been about eight municipal bankruptcies per year in the U.S. for the past four decades. Chapter 9 filings are relatively rare because they provide no financing, 5 and even in these rare cases, municipalities have demonstrated ability to service debt on essential services infrastructure, such as water and sewer districts.

A holistic view is essential, particularly with regard to the critical relationships between state and local budgets. School district budgets, for example, are often funded at the local level from property taxes, but they also rely on revenue from state aid programs and federal grants. Therefore, it is often difficult to completely extricate the finances of one governmental entity from another. In some cases, a municipality’s stellar creditworthiness may be negatively impacted by fiscal turmoil elsewhere in the state.

Even as municipal defaults remain rare, they continue to garner top headline attention when they occur. It is important for potential and existing muni market investors to remain focused on the facts, downplay the hype, and keep in mind that the municipal market continues to offer predominantly high-quality, low volatility fixed income opportunities for vigilant investors.

A New Landscape

Until the 2008 financial crisis, insurance backed 54% of outstanding municipal bonds,6 but it is now prohibitively expensive and rare. Bond insurance coverage allowed investors to enjoy triple-A ratings on the bonds they purchased. The introduction of private bond insurance offered by monoline companies in 19717 provided a win- win-win scenario in the muni market: municipalities were able to issue debt at lower rates and higher volumes; investors gained liquidity and assurance against the risk of default; and insurers were able to offer a profitable product. The scenario unfolded when insurers — hard hit by the financial crisis — began to suffer credit downgrades. By the end of 2010, many of the major muni insurers had lost their coveted triple-A ratings, leaving them unable to bring value to the issuer.

The responsibility for assessment of the creditworthiness of a bond issuer now falls on investors themselves. With the monolines missing in action, investors must rely on their own or their advisors’ judgment and due diligence. The scarcity of bond insurance inflicts a double whammy on state and local governments: precisely at the time when municipal revenues are down and shortfalls are expected beyond 2011, they are unable to borrow at the reduced rates formerly afforded them through the purchase of bond insurance.

In this environment, it is not surprising that bond issuance is drastically down. But it is not simply the lack of insurance and elevated borrowing rates that are to blame. Demand has also waned, coinciding with the end of the federal Build America Bond (BAB) program. BAB program incentives that were set to expire at the end of 2010 created an artificial spike in issuance during 2010 with a subsequent lull that has continued throughout 2011. Average weekly muni bond issuance through April of 2011, for example, was $3 billion, down from an average of $8 billion per week in 2010.8 By October 2011 issuance was up, but remained 23% below the same period in 2010.9 Another key factor is the reticence of state and municipal governments to take on new debt, which has relegated bond projects into a holding pattern until economic indicators improve.

Idaho traditionally ranks at or near the bottom in new issue volume. However, the decline in the number of issues and their size over the past few years is significant for Idaho, and new deal volume is expected to remain low in the near-term.

Idaho’s Economic Outlook is Positive

Despite the low volume of new issues, the Idaho municipal market presents attractive opportunities for Idaho residents who seek tax-exempt income and relatively low risk exposure.

Idaho’s longstanding culture of fiscal conservatism is serving it well in trying times. In March of 2011, Standard & Poor’s upgraded the state’s credit rating to AA+, one notch below the highest rating of AAA. S&P cited the following factors as contributing to the rating increase10:

• Structurally balanced operations despite the economic downturn

• Proficient management of the state’s pension and benefits liabilities

• Strong economic growth over the past decade

• Discipline in building capital reserves

• Constitutional ban on long-term general obligation debt

• Low debt ratio mandates

 

The S&P upgrade may come as a surprise to some, but not to those who are familiar with the specifics of Idaho’s economy. Idaho now ranks fifth among all U.S. states with regard to economic outlook, as measured by the ALEC-Laffer State Economic Competitiveness Index.11 This marks a step up two notches from last year’s ranking of seventh.

The same index also shows that Idaho fell, in terms of economic performance, from a ranking of 10 in 2010 to a ranking of 17 in 2011, but this has not prevented the state from successfully maintaining its fiscal restraint. In keeping with the state’s culture of cautious conservatism, finances are projected with a healthy dose of circumspection as a matter of policy. At fiscal year-end on June 30, 2011, Governor C.L.“Butch” Otter was pleased to announce that general fund revenue was significantly higher than expected, with total receipts up 7.9% over fiscal 2010.12

Governor Otter and the state’s legislators have the political support needed to continue to balance the budget, fund pensions, manage healthcare costs, and are making robust efforts to perpetuate Idaho’s economic vitality. They prefer to leave little to chance, taking concrete action to preserve the state’s positive momentum. “Project 60,” for example, aims to grow the state’s gross domestic product, measured $55.4 billion in 2010,13 to $60 billion. While it appears that no target date has been set to meet that goal, a wide range of activities is underway to stimulate the economy. Among them are incentives to retain Idaho’s current employers and to entice new companies to set up shop in the state. The Project 60 program also explicitly aims to nurture organic start-ups and promote foreign direct investment.

That said, Idaho is not without its trouble spots. In March 2011, Boise County initiated perhaps the first Chapter 9 bankruptcy filing in the state’s history.14 Yet this bankruptcy was not the result of crushing bond debt, as one might imagine. On the contrary, the county had virtually no bond debt. The bankruptcy resulted from a December 2010 federal judgment against the county in the amount of $4 million.

The jury in the case found that Boise County violated the federal Fair Housing Act in its dealings with a developer to build a 72-bed residential treatment facility. The $4 million judgment, plus $1.4 million in legal fees, represents about 57% of the county’s $9.4 million operating budget. The county filed for bankruptcy protection as a last resort, after county officials ran out of options: they lost their appeal of the court judgment; several rounds of negotiations with the plaintiff ’s attorneys proved unsuccessful; and the county’s risk insurance benefit claim was denied.

The above scenario highlights a few key points. First, municipal bond defaults are very rare nationwide, and Idaho is no exception. No one involved with the Boise County case could recall any other city or county bankruptcy ever filed in the state. Second, the reason why bankruptcies are rare is that Chapter 9 filings provide no financing, and hence, no liquidity to serve debt. Other available options are generally preferable. Finally, the example of Boise County illustrates very clearly the considerable depth of due diligence required to accurately assess a municipality’s creditworthiness. Highly experienced professionals can help in this regard, and resident Idahoans have the added advantage of proximity to the latest news and issues affecting the state’s municipalities.

The Idaho Tax-Exempt Fund – it’s worth a look.

Muni Bond Investments: Principal Considerations

Investors who seek income exempt from federal income, federal alternative minimum, and Idaho state income taxes, may find that Idaho municipal bonds suit their needs. Potential options include purchasing a single municipal bond, often held to maturity, or investing in a municipal bond mutual fund. Not every investor will benefit from the tax-exemption, however. Those who invest primarily through a tax-advantaged account, such as an IRA, 401(k), or other tax-deferred retirement account, will not realize the tax benefits of municipal bonds but may find them otherwise suitable as a relatively low-risk income stream. Held in taxable accounts, municipal securities have clear advantages, particularly for investors in higher tax brackets.

It is relatively easy to determine the effect of tax-exempt status on returns by using the following formula to compute an investment’s “tax-equivalent yield”:

This formula helps determine whether the yield on a tax-free investment is higher than the after-tax yield of a non-exempt investment. To illustrate, given tax brackets of 25%, 28%, and 35%, and a hypothetical tax-free yield of 3.00%, a taxable investment would need to provide an even higher yield in order to deliver a higher actual return.

A higher tax bracket lowers the denominator of the equation, producing a higher tax- equivalent yield. Conversely, investors in lower tax brackets may find better yields in taxable alternatives.

 

 

The information and example above are provided for illustrative and educational purposes. They are not intended to be, and should not be construed as, legal or tax advice. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for all investors. The municipal bond market can be volatile and significantly affected by changes in interest rates; adverse tax, legislative or political changes; and the financial condition of the issuers of municipal securities. Tax laws vary from state to state. Any particular state’s laws may affect the applicability, accuracy and completeness of the information and examples above. Please consult an attorney or tax professional regarding your specific legal or tax situation.

 

 

(c) Saturna Capital Corporation

www.saturna.com