Municipal bonds have long been favored by investors looking for more stable returns and tax-exempt income, but recent high-profile bankruptcy filings by a handful of U.S. cities have some wondering whether these securities remain a compelling investment option. In our view, the answer is yes, especially for those in higher income brackets. However, financial challenges in a number of cities underscore the importance of active management and thorough research when it comes to investing in municipal bonds.

Though pressures have been building on local municipalities for some time, the sudden increase in high-profile bankruptcy filings has taken some by surprise. Nevertheless, it is something our bond team has been warning clients about for a while, given the lower revenues and ever-escalating labor costs that have been pressuring cities. Furthermore, it is something that we have been monitoring closely, using our extensive research capabilities in an effort to protect clients from troubled securities.

Putting current events into context

Despite the sudden prevalence of Chapter 9 filings, which provide financially distressed municipalities protection from creditors while developing a plan for adjusting debts, such actions are extremely uncommon. We expect them to remain so. As shown in Figure 1, the actual number of annual bankruptcy filings in the U.S. is quite small.

After three California cities filed or voted to file for bankruptcy this summer, Moody’s Investors Service issued a report that found most defaults in the public sector were directly related to failed enterprises and other special projects. Instances in which municipalities appeared to declare bankruptcy as a strategic tactic to reduce or restructure debt were unusual, and the rating agency expects them to remain so.

Overall, Moody’s anticipates that “even the most financially distressed credits will likely continue to muddle through and pay their debts.” This is largely because filing for Chapter 9 protection is a protracted, difficult process that no entity is eager to undergo. Not all states allow cities to file for bankruptcy, and those that do have measures in place to ensure that all other options are first explored, preventing Chapter 9 from becoming a quick fix. Furthermore, reorganization is rarely a cure-all, because many pensions and bonds are protected from bankruptcy proceedings. Additionally, judges make the final call regarding which contracts can be broken. Thus, taking the Chapter 9 route could still leave a city with a pile of outstanding debt obligations and a damaged credit rating to boot. Last, most politicians understand that their ability to access credit lines for special projects when the economy improves could be severely hampered if they have not honored a moral obligation to pay past debts.

As shown in Figure 2, most of the troubled municipalities have been centered in California, where the cities of San Bernardino, Stockton and Mammoth Lakes recently voted to declare bankruptcy. Although cities in the Golden State face some pressures particular to California (such as a heavy reliance on property taxes that have been damaged by the weak housing market and a limited ability to raise taxes), the drivers that led each of these cities to consider bankruptcy were unique. Stockton was buried under a mountain of loans for a downtown redevelopment project after the financial crisis caused property values to crash. Mammoth Lakes lost a breach of contract case with a developer, leaving the city with a hefty judgment that it couldn’t pay. San Bernardino struggled to reconcile lower tax revenue with rising pension costs like so many other cities, but it had the added pressure of mismanagement (there is currently an investigation under way looking into accusations that city officials falsified financial reports for more than a decade).

In-depth research is essential

Recent Chapter 9 filings haven’t deterred investor interest in municipal bonds. New issues continue to come to market, and demand remains strong. Part of the reason is that many municipal bonds currently yield more than U.S. Treasury bonds, and they offer tax-exempt income, which is of particular interest to investors in this low-rate environment. We believe the tax-exempt status of municipal bonds makes them a very compelling investment, given the likelihood of higher federal income taxes in the coming years. (For more information about potential changes in federal tax rates, see our recent papers on the subject: “Changes on the Horizon for Tax Rates” and “Wealth Management Strategies for a Changing Tax Environment.”) Although there are risks in the municipal bond sector, our fixed-income team has a proven track record of uncovering attractive opportunities in this area.

Capital Group Private Client Services portfolios do not hold any of the bonds that have come under pressure in the three aforementioned California cities. Portfolio managers have generally avoided city-issued bonds, with a view that investors are not being adequately compensated for risks in this sector. One of the challenges of investing in the municipal bond market is that it is impossible for rating agencies to stay current on all of the local issuers. As a result, rating changes tend to be backward-looking. For example, just before news broke that the San Bernardino city council had authorized the city attorney to begin to seek Chapter 9 bankruptcy protection, Standard & Poor’s rated San Bernardino lease revenue bonds at BBB+. After the announcement, the rating fell to CC. Furthermore, the quality of financial reporting among local municipalities in general tends to be quite poor.

These challenges highlight how active management and professional research are now essential components for those investing in the municipal bond market. With so many cities facing tight budgetary pressures, our portfolio managers expect to see more bankruptcy filings by local municipalities. However, our team anticipates that the overall number of Chapter 9 filings will remain small. Risks in the sector should start to ease as property values appreciate and cities address some of their pension issues. Unfortunately, it is extremely difficult to predict which cities will come under strain next, so in-depth research is essential. At Capital Group Private Client Services, we rely on our own analysis for investment decisions and devote extensive time, energy and resources to our research process. Our fixed-income team will continue to take the same fundamental approach to investing that has helped it avoid troubled issues thus far.

In collaboration with our institutional affiliates, we have an entire team of municipal bond professionals, analysts, managers and traders dedicated to navigating the fixed-income market on behalf of our clients. Bond analysts regularly meet with key players in the areas they cover, helping them to differentiate between municipalities that are risky and those that present good value for our clients. On-the-ground inquiries and investigations have directly helped the team to identify worrisome trends long before they were evident to the broad market.

Consistent revenues are key

Our fixed-income team concentrates on finding debt securities that are supported by high-quality revenue streams as identified through our deep, fundamental research. Because of the risks in certain local government debt, our fixed-income team is only interested in investing in municipal bonds with transparent sources of revenue that can be easily assessed. For this reason, we tend to favor revenue bonds—particularly those with revenue streams that will continue to come in even if the entity declares bankruptcy. Holders of these types of bonds also tend to be more protected in the event of a default, because city residents will still pay for essential services such as electricity and water even if the utility fails to meet its debt obligations.

What’s more, fixed-income analysts frequently collaborate with the firm’s equity analysts within various sectors of interest to further the depth of their debt security research.

Because the primary goal of the Capital Group Private Client Services fixed-income team is capital preservation, managers are particularly sensitive to credit risks within the municipal bond markets and have been positioning portfolios accordingly. The recent increase in Chapter 9 filings did not come as a surprise to our analysts and did not necessitate changes in how they are positioning client portfolios. And although managers are always looking for ways to improve yield, they will not do so at the price of what they believe to be unacceptable risk in client portfolios. Now more than ever, wealth preservation depends on the ability to identify high-quality debt securities that will uphold their value regardless of broader pressures that may be affecting other issuers in the market. n

The statements expressed herein are current as of the date noted, and are subject to change at any time based on market or other conditions. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. ©2012 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited. September 2012