Municipal bond prices have been weaker over the past several months due to ongoing negative media attention given to the potential for rising defaults. Investor nervousness about the potential for more defaults has led to redemptions from municipal bond funds, and selling of individual bonds.
We believe many of the media reports and negative commentaries have greatly exaggerated the potential default risks. Yes, careful credit evaluation is more important than ever and challenges do exist in many states (California and Illinois ) and cities (Vallejo , CA and Harrisburg , PA
Municipal bonds comprise a nearly $3 trillion market, which is made up of thousands of issuers in hundreds of healthy sub-markets. Most municipal debt is structured to be as immune as possible from economic swings, and many issuers have set aside rainy day funds to help them weather difficult economic cycles. On average, municipal debt service represents less than 10% of most state budgets. In the case of general obligation bonds, payments of interest and principal are backed by the full faith and credit (i.e. taxing power) of the issuer. It should also be noted that State governments cannot file for bankruptcy, cease to exist, reorganize, or be liquidated like a corporation. State governments have a requirement to balance their budgets each year. If budget shortfalls occur, then debt service payments carry a higher priority than other expenditures.
In our opinion the market is pricing in a higher level of defaults than will actually occur. The recent rise in municipal bond interest rates and subsequent decline in their prices has created an opportunity for fixed income investors to buy quality securities at cheaper prices, especially for those in higher income tax brackets.
