Q&A: Navigating today’s challenging municipal bond environment

kjzNews that Stockton, California, has moved one step closer toward bankruptcy highlights the financial challenges many cities and states face today. As a result, some may wonder what this means for municipal bond investing. For answers, we sat down with fixed-income portfolio manager Karl Zeile.

Karl, why are so many municipalities facing challenges now, especially since the U.S. economic recovery appears to be taking hold?

Local governments are being hit from a number of different angles. Property taxes are a primary revenue source. However, because of the weak housing market, property taxes have been flat to declining for the past few years. Meanwhile, the difficult economic climate has created higher demand for government-provided services right when the full cost of generous pension and post-retirement benefits is being fully realized. Those packages have become enormously expensive. In addition to revenue stagnation and cost pressures, local governments also face challenges on the investment side because they made certain assumptions about stock market returns that haven’t played out as expected.

Why are so many California cities grappling with potential bankruptcies?

California is among the states that allow local governments to file for bankruptcy, which makes for interesting headlines. In addition, California cities are somewhat hampered in their abilities to raise taxes because of Proposition 13, which puts limits on the amount property taxes can be increased. All local governments rely heavily on property taxes, and California is no exception.

Have the fiscal challenges facing local governments changed your approach to municipal bond investing?

The market is now recognizing a distinction that we have made for years—that there’s a very big difference between special revenue bonds and local appropriation bonds. A special revenue bond is any debt obligation with a dedicated source of revenue to pay back bond owners. For example, if a city needs a new sewer system, the local government will add a special sewer fee to the property tax bill of every landowner who uses the system. These are very different from local appropriation bonds, which involve the local government’s promise to pay bondholders with money not collected from a unique revenue source. Local appropriation bonds don’t carry that additional protection, so there can be a very different credit risk associated with them.

Historically, rating agencies and the market have viewed both of these bonds as related and having relatively similar creditworthiness. We’ve always felt that the relationship between them isn’t as tight as some may think. We believe special revenue bonds are a more secure structure for bondholders and have largely avoided local debt supported solely by a promise to pay. We don’t think local appropriation government debt should be completely avoided, but we do think it’s very important to understand how the debt is structured. The examples of Stockton and Vallejo (a California city that recently exited bankruptcy protection after filing Chapter 9 in 2008) demonstrate that special revenue bonds are treated differently in the negotiating process. In both cases, the special revenue bonds’ dedicated revenue streams were upheld, so payments on the debt continued (or are likely to continue, in the ongoing case of Stockton) even after other municipal debt was renegotiated.

Have you made any changes in client holdings of municipal bonds?

We aren’t doing anything dramatically different in client portfolios because these recent events simply reinforce the case for how we’ve been investing for years. We don’t own any Stockton bonds in Capital Group Private Client Services portfolios. Coming out of this global economic crisis, local governments are uniquely vulnerable, so we have been particularly cautious in our municipal bond investments. Local governments vary greatly, and we conduct very thorough research before making an investment.

Are municipal bonds still safe?

Just as you can’t make a blanket statement and say that all corporate bonds are safe, you can’t say that all municipals are safe. It has never been more important to know what you’re investing in than it is right now in the municipal bond market. Some municipal bonds will default and some will be downgraded, but others will offer solid performance. It’s our job to make sure that our clients invest in high-quality municipal bonds with strong fundamentals.

Could weakness in certain municipalities make it harder for local governments to find funding now, particularly in California?

We’re not expecting any contagion, because we believe the market recognizes the differences among local governments. These instances just bring us back to what we’ve been talking about for years: the benefits of diversification, of knowing what you own and of having a professional investment manager to look at each individual issuer and monitor the sources of revenue. Capital Group Private Client Services and its institutional affiliates have an entire team of municipal bond professionals, analysts, portfolio managers and traders dedicated to navigating this changing landscape on behalf of our clients. n

 The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, reflect the views of one individual and are subject to change at any time. 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. 

Quarterly Commentary

Q2 2015

Click here to read the Summer 2015 issue of Quarterly Insights, which discusses the emergence of the fast-casual dining industry, outlines how women in India are changing the investment landscape and shows how sound habits lead to greater happiness.