January 18, 2011
Wealthy investors, seeking safe tax-free income, have historically centered their portfolios on municipal bonds. The fiscal problems faced by many states and local governments, however, are leading many to question that strategy, none more vocally than the analyst Meredith Whitney, who predicted “hundreds of billions” in municipal bond defaults in a recent 60 Minutes interview.
Leading the challenge to Whitney’s bold forecast is one of the organizations charged with monitoring the ability of states to meet their debt obligations – the ratings agency Standard & Poors. Robin Prunty, a senior director in S&P’s public finance ratings group, exemplified the agency’s standpoint while speaking at a luncheon sponsored by the Boston Security Analysts Society last week.
“We don't feel that US state and local governments are facing a debt crisis where we are going to see widespread defaults,” Prunty told her audience.
I was reminded of a similar talk given by an S&P analyst several years earlier, assuring the audience that the housing market had stabilized and securitized mortgage obligations deserved their investment-grade ratings.
Everyone knows how that turned out. Nonetheless, I side with S&P over Whitney in this debate.
Munis will face many challenges this year, though – just not the defaults that Whitney predicts. I’ll discuss the problems muni investors may face, but first let’s look at what Prunty said about public finances.
Refuting Whitney
The clearest metric that indicates debt levels may be unsupportable is the ratio of debt service payments to revenue. On that score, state governments’ debt burdens are modest, according to Prunty, averaging approximately 4%. That compares to 15% for sovereign governments rated AAA by S&P.
The comparison to sovereign debt is not fair, though, Prunty argued. She said that most municipal debt is amortizing, requiring regular payments of principal and interest. Sovereign debt typically pays principal at maturity.
Moreover, she said, most states have managed their budgets very effectively through the recessions and disruptive credit conditions, either by raising taxes, drawing on reserve funds, or issuing additional debt – in some cases at variable rates. “Overall,” she said, “the states are pretty well positioned.”
As a result, approximately 99% of US public finance debt is rated investment grade by S&P, and those ratings have been improving over the last two decades. Eleven states are rated AAA, and most of those have been for decades. Only two states, Illinois (A+) and California (A-), are rated single-A, and Illinois is the only state currently on negative credit watch. Arizona, California, Florida, Ohio, Maine, and Rhode Island are among the more troubled states, which Prunty attributed to their entering the recession earlier than most other states.
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