Fixed income update 01-14-11

Delaware Investments response to ongoing headline risk in the municipal market

Over the past several months, a few highly visible commentators have predicted a massive wave of bond defaults in the municipal bond market, with debt repudiations that could reach "hundreds of billions" of dollars over the next year. Most of these analysts do not have direct experience with municipals. For example, high-profile equity analysts, including Meredith Whitney, have argued that the structural problems in U.S. public finance are similar to what occurred in the subprime housing market.

We at Delaware Investments strongly disagree with the prediction that there will be a systemic breakdown in U.S. public finance that could lead to a tsunami of bond defaults and Chapter 9 bankruptcy filings.

2011 municipal outlook: Concerned but not alarmist

  • We acknowledge that the finances of state and local governments have been severely challenged by the revenue declines brought on by the recession of 2007–2009.
  • Calendar year 2009 was the worst year on record with an 8.5% drop in state tax revenues. 1 Over the past three fiscal years state governments have closed budget shortfalls of more than $230 billion. 2 Additional shortfalls will have to be addressed in FY2012 just as the level of federal assistance provided under the American Recovery and Reinvestment Act of 2009 is winding down.
  • However, state and local governments have a great deal of flexibility and fiscal and management tools to address sizeable budget gaps. All but one of the 50 states are required to enact balanced budgets each year. 3 States have used a wide variety of measures to offset budget imbalances through spending cuts, increased taxes and fees, drawing down reserves, delaying payments, deficit financing, selling assets, and using federal stimulus funds.
  • Some states' governors (New Jersey's and Illinois's, for example) have taken overt actions to address long-term structural problems, and we expect that other governors and their state legislatures will also make the tough choices either by enacting material cuts in spending or taking the political heat and raising taxes to resolve large budget deficits.
  • Recently, state tax revenues have begun to recover. These higher revenues are expected to help offset the decline in federal stimulus funding. Preliminary tax collections from the third calendar quarter of 2010 (the first quarter of fiscal year 2011) indicate an increase of nearly 4%. 4 This is the third-consecutive quarter that overall tax revenues have grown, even though revenues are still about 7% below pre-recessionary levels.
  • Local governments have adopted similar revenue raising and spending actions to address the cutbacks in state aid and the drop in sales tax and property tax revenues. These actions have included layoffs, furloughs, and reductions in service and hours of operation.
  • With back-to-back declines in assessed valuations and likely cutbacks in state assistance, local governments should remain under pressure, in our opinion. However, we believe that the vast majority of state governments will make the tough decisions to balance their budgets and pay their debts.

Municipal defaults and bankruptcies: An overblown topic

  • In our opinion, the fiscal stresses now being experienced by municipal governments do not imply a rash of municipal defaults and bankruptcy filings (under Chapter 9) in 2011, or in the foreseeable future.
  • While the host of bearish commentators allege that "this time it is different," the facts remain that municipal defaults have historically been an extremely rare occurrence. While the actual number of defaults may rise, we still expect the number to remain very small when compared to the 90,000 units of government — 55,000 of which are estimated to have issued debt. 5
  • Muni defaults are rare and we believe that they will remain very episodic. There have been 617 muni bankruptcy filings since 1937 at the end of the Great Depression. 6 Most of these were special tax districts and entities that did not have any debt outstanding. A total of 246 Chapter 9 filings have occurred since 1980. Of the filings since 1980, only 45 have been a city, village, or county, with most being municipal utilities, hospitals, or special purpose districts. 6
  • In 2010, six municipal entities filed under Chapter 9. By comparison there were 11,000 corporations that filed for bankruptcy protection under Chapter 11 — and this has been the annual average filing amount for corporations since 1983. Since 2000, the annual number of Chapter 9 muni filings has been between 4 and 10. 6
  • State governments are not permitted to file for bankruptcy protection.
  • About 24 states either do not permit a municipality to file for bankruptcy or do not have specific authorization. Of the 26 states that do permit bankruptcy filings, many of these require prior approval of the filing by a legislative or regulatory body. 6

Default statistics: Muni default rates remain much lower than those of corporate bonds

  • While city and county defaults were common in the 19th century, they are rare now. Moody's, which rates 18,000 municipal borrowers, examined municipal defaults of its rated borrowers from 1970 to 2009. There were only 54 rated municipal bond defaults compared to 1,707 rated corporate defaults. 7, 8 Only four of these muni defaults were counties and two were cities. And 78% of the defaults were in the hospital and housing sectors.
  • Standard & Poor's conducted a similar municipal default study. Between 1986 and 2008 there were 39 rated municipal defaults compared to 1,606 rated corporate defaults. 9,10
  • In 2009, there was $108 billion in corporate defaults versus $6.3 billion in municipal defaults.
  • When municipal defaults do occur, the recovery rates are much higher for municipals than for corporate bonds. According to Moody's, the median recovery rate for rated municipal issuers was between 85 cents and one dollar. Recovery rates on defaulted corporate bonds and loans ranged from 54 cents on first-lien bank loans, 37.5 cents on senior secured bonds, and 22.4 cents for senior subordinated bonds. 7,8
  • While muni defaults may rise in 2011, we expect they are likely to be limited to a handful of issuers and a tiny fraction of the "hundreds of billions of dollars" figure. In our opinion, defaults will continue to be concentrated in healthcare, retirement communities, and land development. Defaults in these sectors should not pose systemic risk to the municipal market.

Muni debt structure and pension/other post-employment benefits (OPEB) liabilities

  • Rollover risk in municipals is not an issue in our view. Most municipal debt is structured to be self-amortizing and paid down over time.
  • We do recognize that there is an elevated level of variable rate debt backed by letters of credit (LOC) that are scheduled to expire in 2011. According to Thompson Reuters, a total of $53 billion in bank guarantees on municipal debt are set to expire in 2011. 11 Many of these LOC backed deals refinanced auction rate securities after auctions began to fail in 2008. Some smaller, lower rated credits may face difficulties in obtaining renewal of their bank letters of credit. But the total amount of debt with expiring LOCs in 2011 is equal to less than 2% of outstanding municipal debt.
  • Municipal borrowers typically structure their debt to achieve level or declining debt service rather than bullet maturities that may need to be refinanced. The average life of municipal general obligation (GO) debt is 12 years compared to 4.92 years for U.S. Treasurys and 6.3 years for general debt issued by Organization for Economic Cooperation and Development (OECD) countries. 12
  • Most municipal debt is structured with longer maturities and a longer average life than corporate or federal government debt. Revenue bonds are generally tied to the useful life of the facility being financed and are structured to be paid by the taxes and revenues that secure the debt.
  • The debt service expense for most state and local borrowers is modest, with debt service costs as a percentage of annual expenditures in the range of 4–8%. 12
  • The debt-to-GDP burdens for local and state GO debt are much lower than distressed sovereign entities such as Greece, Ireland, and Italy. 12
  • Unfunded pension liabilities and postretirement healthcare costs of state and local government are a very large and growing set of obligations that need to be addressed. But developing reforms to address these obligations will require a multiyear approach. We have seen some states enact reforms to partially address the pension funding problems but, in our opinion, more still needs to be done. These are long-term structural concerns and not an immediate liquidity crisis that might lead to impairment of the current payment of benefits.


  1. U.S. Census Bureau, State Government Finances Summary: 2009 Governments Division Briefs, Jan. 2011.
  2. National Governors Association and National Association of State Budget Officers, The Fiscal Survey of States, An Update of State Fiscal Conditions, Fall 2010.
  3. National Conference of State Legislatures, NCSL Fiscal Brief: State Balanced Budget Provisions, Oct. 2010.
  4. Dadayan, Lucy and Boyd, Donald, "State Tax Revenues Rebound Further, Growing for Third Straight Quarter," Nelson A Rockefeller Institute of Government, Nov. 30, 2010.
  5. Congressional Budget Office, Fiscal Stress Faced by Local Governments, Economic and Budget Issue Brief, Dec. 2010.
  6. Spiotto, James E., "Historical and Legal Strength of State and Local Government Debt Financing," presented to the Society of Municipal Analysts, Oct. 2010.
  7. Moody's Investors Service, U.S. Municipal Bond Defaults and Recoveries, 1970–2009, Special Comment, Feb. 2010.
  8. Moody's Investors Service, Corporate Default and Recovery Rates, 1920–2009, Feb. 2010.
  9. Standard & Poor's, U.S. Public Finance Defaults and Rating Transition Data: 1986–2009, March 3, 2010.
  10. Standard & Poor's, Default, Transition, and Recovery: 2009 Annual Global Corporate Default Study and Rating Transitions, March 17, 2010.
  11. Wall Street Journal, "New Hit to Strapped States," Jan. 14, 2011.
  12. Rai, Vikram, "U.S. Municipal Strategy Notes, Rollover Risk in Municipals: Not an Issue," Citigroup Global Markets, Municipals, Jan. 6, 2011.

The views expressed were current as of Jan. 14, 2011, and are subject to change at any time.

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These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Any reproduction of these materials, in whole or in part, or the divulgence of any of the contents thereof, without prior consent of Delaware Investments is prohibited. Certain information contained herein has been obtained from sources that Delaware Investments believes to be reliable as of the date presented; however Delaware Investments cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Delaware Investments has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. Delaware Investments and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of Delaware Investments or its affiliates.

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