Within the space of a few weeks at the end of June and in early July, three California cities – Stockton, Mammoth Lakes, and San Bernardino – announced their intent to file for bankruptcy protection as part of their efforts to address relatively severe and isolated financial difficulties. According to American Century Investments’ Municipal Bond (Muni) Team, Stockton’s and San Bernardino’s difficulties stem from long-term structural problems with their budgets, while Mammoth Lakes was put in this position primarily by a large, unfavorable legal judgment.
Our muni team is California-based, and includes experienced portfolio managers working closely with seasoned municipal credit analysts. They are monitoring California’s credit situation carefully, as part of their established procedures. (This team has actively managed muni portfolios and analyzed the muni market since the 1980s.)
As a result of the team’s procedures, the direct exposure of American Century Investments’ muni portfolios to the financial difficulties of these three cities is minimal. None of the portfolios has any exposure to debt tied to the budgets of these cities. Our California high-yield muni portfolio owns a small position in a tax revenue bond issued by a development in Stockton, but it has been prerefunded (refinanced) and is fully secured by U.S. Treasury securities – the team says it now essentially trades like a AAA-rated bond.
In light of what’s happened in California, the team believes it’s important to put those events in context. Municipalities in general are experiencing financial stress caused by current economic conditions, but the team views most muni debt issuers as resilient. State and local governments have cut spending and raised taxes to cover their large budget shortfalls. After several difficult years, the fiscal outlook for most state and local governments is stabilizing, but the stress will likely continue as long as the U.S. housing and employment markets remain depressed and the economy stays sluggish.
To compensate, most municipalities have demonstrated increased fiscal responsibility, including cutting expenses and overhead, reducing potential pension liabilities, and, in some cases, raising taxes. Defaults have declined steadily since 2008. Data indicates that state tax revenues have improved since 2008, attaining levels at or near their pre-recession peak.
As a result, the team believes strongly that the three recently headlined California cities do not represent the start of an incoming tsunami of systemic muni bankruptcies and defaults in California or nationwide. Instead, they’re just small, isolated ripples that made bigger waves in the media than they did in terms of overall municipal credit quality. To put these three cities in a broader perspective, within California alone, the combined number of cities, counties, school districts, and community colleges totals over 1,500. Most local governments that the team has reviewed are still in good financial condition despite the weak economy.
The team continues to believe (counter to widely publicized national predictions in 2010) that muni defaults will remain relatively isolated events that are most likely to occur at the local level. The team does not believe any states will default, though further state credit rating downgrades are possible. The team thinks credit rating downgrades, in general, will far outnumber actual defaults at both the state and local levels, and that most of the downgrades will likely be at the local level, not the state.
Unfortunately, these rating downgrades and isolated defaults will continue to generate negative headlines and muni market volatility. There will likely be more isolated cases of cities either going to brink of default or defaulting on some lease obligations. During the last five years, we believe the muni market has transformed from a rates/yield-driven market to a credit risk-driven market. We believe this transformation provides advantages to investors who have professional municipal analysts reviewing each individual credit. This highlights a key potential benefit of investing in well-managed muni funds with professional muni credit analysts, versus buying individual munis on your own.
One traditional muni facet that experienced muni market professionals frequently discuss with investors and advisors is the relatively low default rate, historically, for high-quality munis. The period 1970-2011, shown below, includes six economic contractions, including the severe 1973-75 and 1981-82 recessions, and, of course, the Great Recession of 2007-09. Even including those recessionary periods, high-quality muni default rates, over rolling 10-year periods, were miniscule. Of course, past performance is no guarantee of future results, but, historically, high-quality municipal credit has been very resistant to default, and even Baa-rated munis have had lower historical default rates than Aaa-rated corporate bonds, as shown below.
Focusing back on California, here are some additional closing comments about California muni credits from our muni analysts:
• They believe part of the reason there was a sudden burst of three bankruptcy announcements bunched together in early summer was that July 1 was the beginning of the fiscal year, when cities had to come clean with their finances.
• The actions of the three cities should not be viewed as a broad indictment of general obligation (GO) bonds issued by local California governments. These local GO bonds (issued mostly by school districts and community colleges) have very strong security features. Under the California constitution, all GO bonds must be voter approved with a specific property tax dedicated to only the repayment of the bonds. Local governments cannot use the property taxes securing the bonds to pay operating expenses. Our muni team believes that in the event of a local government bankruptcy, GO bonds would still continue to be paid since, under state law, the property taxes securing the bonds can only be used to repay the bonds.
• California has a very large, diverse economy and a similarly large, diverse muni market. The California muni market has (and well-managed muni funds typically own) securities from many different types of issuers, including electric utilities, water and sewer utilities, airports, land-secured project developers, toll roads, hospitals, and colleges) which are not subject to the same types of budgetary pressures as cities. City budget problems typically have no direct impact on these other types of munis.
• Each individual muni issuer is unique, even within the same sector and geographic location, and can have dramatically different credit fundamentals. Many local governments we review in California still have substantial reserves, unlike the municipalities in the news.
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Letter ratings indicate the credit worthiness of the underlying bonds in the portfolio, and generally range from AAA (highest) to D (lowest).
The opinions expressed are those of the Muni Team at American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.