Lately there have been plenty of news stories in regards to the struggles of California and other states as they try to balance their budgets. The budget woes facing the states not only put financial strain on government programs and services but also on municipalities abilities to service their debt (municipal bonds). Included here is an article we agree with from the Vanguard Group with their comments on tax exempt (muni) bonds and state budget problems.
Investors in municipal bonds are understandably concerned about the historic budget challenges that many states, municipalities, and local government entities are facing during this prolonged economic slump.
It’s important to note that all but a handful of states have met their budget deadlines. But perhaps the most publicized situation is the state of California, the largest issuer of municipal securities. Despite technically having a budget in place, the state is struggling to plug a massive budget deficit. To conserve cash, the Golden State has decided to issue interest-bearing “registered warrants” (known informally as I.O.U.s) to pay certain creditors, such as vendors and taxpayers expecting refunds. However, bondholders will not be paid in registered warrants.
“When the dust settles, we’re confident that the states and municipalities will have a mix of spending cuts, tax and fee increases, federal stimulus payments, and reserve-tapping that will get them through their crises,” said John Carbone, principal and portfolio manager of Vanguard’s California Tax-Exempt bond funds.
Other states are considering, or have implemented, a variety of tactics—from partial payments to state employees to taxes on candy and ringtones—to balance budgets or to keep operating while negotiations between governors and legislatures continue.
However, there’s more to the story than meets the eye—or appears in the headlines. Vanguard’s analysts conclude that the threat of a state default or widespread local defaults is highly unlikely.
A long history of payments
State and local governments have a long history of meeting investor obligations, even in periods of extreme economic stress. In any case, municipal issuers are reluctant to default (under federal law, there’s no provision for states to declare bankruptcy, although local governments have the ability to do so in some states) because they could be shut out of the financial markets for years.
“When the dust settles, we’re confident that the states and municipalities will have a mix of spending cuts, tax and fee increases, federal stimulus payments, and reserve-tapping that will get them through their crises,” said John Carbone, principal and portfolio manager of Vanguard’s California Tax-Exempt bond funds. “That’s not to say it will have been easy.”
Downgrades more likely than defaults
In California, it’s possible that the financial ratings of the state and local governments will be downgraded. But several points seem to make defaults improbable:
• California’s constitution requires that state general-obligation bond payments take priority over other payments except for those that fund education. At the local level, general-obligation bonds include voter-authorized provisions that permit payments to be funded without limit by property tax increases.
• Local government’s essential-services revenue bonds—which get their name because they’re used to finance water, sewer, power, and similar utility services—permit the bond issuer to raise rates to meet bond obligations.
• Most municipalities and school districts have reasonable debt burdens, that can generally be met, if needed, by revenues independent of regular state contributions.
• Although state and local bonds secured by income such as sales taxes, tourist-related revenues, and gas taxes are especially vulnerable to the economic slowdown, limits on bond issuance help reduce risk.
Similar circumstances apply to other states for which Vanguard also offers state-specific tax-exempt mutual funds—Florida, Massachusetts, New Jersey, New York, Ohio, and Pennsylvania. The states are under various degrees of stress, but the risk of default at the state level and, generally, at the local level seems low.
Investing with skepticism and diversification
Vanguard’s conclusions about state finances come from our credit analysts, who carefully and closely monitor state fiscal conditions and the credit quality of Vanguard’s fixed income investments.
The credit analysis staff approaches its job with an informed skeptic’s view—its analyses are independent of those published by rating agencies—as it reviews the fixed income issues that are candidates for the Vanguard portfolios and keeps close watch on issues already in the portfolios.
Also helping mitigate risk for shareholders is the wide diversification that characterizes each of Vanguard’s state-specific tax-exempt funds, a cornerstone of Vanguard’s investing in the tax-exempt sector.
• Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
• Bond funds contain interest rate risk, the risk of issuer default, and inflation risk.
• Diversification does not ensure a profit or protect against a loss in a declining market.
• Because each state-specific fund primarily holds securities issued by that state and its municipalities, these fund are more sensitive than general tax-exempt funds to unfavorable economic developments within the state.
• Past performance is no guarantee of future results.