Walking On Eggs?

Two items last week were worrisome for the municipal market.  Both involved Illinois credits, but the problems described are not limited to Illinois.  The first was the announcement that the Chicago Board of Ed is selling bonds this week with a rating of B and minimum denominations of $100,000.  It is bad enough that a school district is far into junk status  (subprime bonds?), but by trying to prevent individual investors from buying the bonds, they are essentially saying, “we do not want to punish small investors should we default on these bond”.

The second item was a press report that in Harvey, IL. the annual required contribution to its pension funds exceeds it annual income.  If they made those pension payments, there would be no money for essential services.  So, they are not making the payments and the funds are grossly underfunded.  How do they get out of this mess?

These unfunded pension problems are shared by a host of states and municipalities, and at some point, they must be addressed.  I fear that many municipalities will use bankruptcy as the solution, and the courts will impose serious haircuts on the bond holders.  That was true in Detroit and is unfolding in Puerto Rico.  The full faith and credit status of GO bonds is not equal to the political clout of pension recipients.  States cannot declare bankruptcy, but those bonds could get downgraded to junk status before they figure out a solution to these problems.  That, combined with bankruptcy filings by smaller entities, could spark selling of munis by individual investors.  Yes, that would be irrational, but as Keynes said, “markets can stay irrational longer than…”

I am not suggesting that investors should be selling their muni bonds or bond funds.  But, they should probably not be reaching for yield these days.  Check the credit status of the bonds they own, and use fund managers that have avoided steeply negative returns during previous periods of market stress.  That stress might not be imminent, but to stretch for yield now in this market is, in my view, akin to walking on eggs.  It might work, but might not be worth the risk.



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