The Shape of Things to Come?

If this is the future of municipal finance, the future doesn’t look so bad.

Those concerned about muni defaults have pointed to Vallejo, California as a harbinger of things to come. The mid-sized city has a population of 115 thousand and a median household income of about $60 thousand—20% above the national average. Nonetheless they promised more than they could afford to their workers, and in May of 2008 the leaders filed for Chapter 9 bankruptcy.

Since then retail investors have lost—nothing? Owners of revenue bonds have of course received full and timely payment of principal and interest. Such bonds are secured by a dedicated cash stream. In the only state-level default of the last 100 years, Arkansas tried to exchange revenue bonds for general obligation bonds. Investors objected. During times of fiscal stress, revenue bonds are preferred.

But even owners of Vallejo’s general obligation bonds have also been fully paid. Either bond insurance has paid the bill or the bonds have been refunded via a credit line provided to the town by a local bank. Even though they are under no legal obligation to do so, the City has made sure that investors haven’t lost out. This is because they will need to access to the capital markets in the future.

Because municipal finance is lumpy. Revenues arrive unevenly, driven by property tax receipts and the retail shopping season. But payments are steady: every two weeks payrolls need to be met. The easiest way to match cash-in and cash-out is via the public debt markets. This is a big reason that municipal default is so rare, and when it does happen, it usually involves small issuers who won’t need to tap the markets later on.

Muni defaults are expensive for the defaulter. That’s why Vallejo’s example is more of a warning to borrowers than it is to investors.

Douglas R. Tengdin, CFA
Chief Investment Officer
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