By Allan S. Roth
Ayear and a half ago, Meredith Whitney appeared on 60 Minutes and boldly declared that massive municipal bond defaults were forthcoming. She said the day of reckoning was imminent, with $160 billion of federal stimulus spending ending and states having to cut funding to municipalities. Since Whitney had been right in predicting the collapse of the housing market, while the likes of Standard & Poor's and Moody's missed the mark, her forecast was linked to a wave of selling.
But this time she missed badly. According to BlackRock, there were 119 municipal default filings last year totaling $6.1 billion, compared with 169 filings totaling $5 billion, in 2010. As investors flocked back to muni bonds and their performance soared, Whitney's credibility dropped. Indeed, by the end of 2011, renowned Princeton economics professor Burton Malkiel wrote an op-ed piece in The Wall Street Journal titled "The Bond Buyers Dilemma," in which he recommended municipal bonds over U.S. Treasuries.
While I've been called e_SDLqMeredith Whitney" on more than one occasion because of my own concerns about municipal bonds, my worries center on a very different issue than the one Whitney raised. This issue is the fact that the fate of municipal defaults will be correlated to how the global stock market performs over the next decade. To be sure, muni bonds have had negative correlations to U.S. stocks in the past, but that's beginning to change.
Corporations have been working for years to shift to defined contribution plansfrom defined benefit pension plans, transferring investment risk to employeesfrom the employer. Governments, however, still owe trillions of dollars to their current employees and retirees in both pension payments and healthcare benefits. In a 2009 paper that has since been published in The Journal of Finance, Robert Novy-Marx of the Simon Graduate School of Business at the University of Rochester and Joshua Rauh of the Kellogg School of Management at Northwestern University examined the size of the liabilities and governments' ability to meet them.
This paper, titled "Public Pension Promises: How Big Are They and What Are They Worth," put the size of state pension liabilities between $3.2 trillion and $4.4 trillion as of 2009, discounted to today's dollars. The professors noted that these liabilities would be even larger because of projected salary growth and additional future service of employees. By contrast, the states had set aside only $1.94 trillion, leaving a substantial shortfall.
In an interview, Rauh noted that when you also combine municipal and county unfunded liabilities and update to today's interest rate environment, the unfunded liabilities amount to $3 trillion to $4 trillion. MIT economics professor Robert Merton, a Nobel laureate, was quoted in the Financial Times as saying that $4 trillion is a minimum amount.By comparison, the total value of issued muni debt is $3.7 trillion, according to the Securities Industry and Financial Markets Association.
In a 2011 paper, Novy-Marx and Rauh estimate that, without policy changes, contributions to government pension plans would have to increase by a factor of 2.5 from their current levels for the systems to be fully funded within 30 years, a common goal.
The easiest way to achieve this goal is to experience a decade of strong stock performance. The weak stock performance since the turn of the century is partly responsible for the current shortfall. In fact, an 8% geometric annual return is being assumed by public pension plans, and a return of that size seems a bit aggressive, given the low rates now being earned on fixed-income investments. The implication is that it would take double-digit annual returns on stocks to get public pension plans out of their mess.
Rauh estimates that, even if public pensions increase funding levels, some are likely to run out of money in 10 to 20 years, when annual payments will rise to more than $300 billion.
COUNTING ON STOCKS
Despite Whitney's prediction of a near-term disaster, it will probably take a decade or two to test whether states and municipalities can meet their obligations to both retirees and bondholders. The biggest single factor in the interim will be stock market returns. If the market has another decade like the 1990s, then much will be well again. But if there is another Lost Decade, the stress on municipal bonds will be extreme. Corporate bonds may even be safer than munis, since most corporations have either eliminated or greatlyreducedtheir defined pension liability.
Proponents of municipal bonds point out that, unlike corporations, states and local governments have unlimited taxing authority. If they run into shortfalls, they can unilaterally raise taxes. That's the next best thing to the federal government's ability to print money.
Still, there are some statutory limitations to raising tax rates, and there are also practical limitations. A concept known as the Laffer curve, named after economist Arthur Laffer, advances the notion of taxable income elasticity. It postulates that increasing tax rates will ultimately increase revenue at a decreasing rate. Eventually, tax increases will result in decreasing tax revenue.
Political risk is also inherent. Officials seeking to be elected or re-elected may not be willing to make the tough choices of raising taxes and cutting services. Even cutting benefits to retirees, if allowed by local law, could have ramifications that politicians are unwilling to accept. Thus, those saying that governments would make the tough choices may be counting on politicians to act very differently than they have in the recent past.
There is always the possibility that the U.S. government could decide to bail out state and local governments, as it did for the financial services industry. But such a bailout may be more difficult in the future since U.S. debt is virtually certain to be much greater by then than it was during the financial bailout. Also, the U.S. government cannot own equity in state and local governments as it did in the corporate bailout.
TESTING THE HYPOTHESIS
The hypothesis is that the fate of muni bonds will become more tied to stock performance, but what are the signs that the correlation of muni bond performance to U.S. stocks is actually increasing? According to Vanguard research, munis and Treasuries had nearly identical correlations to stocks through 2007. But after the stock crash of 2008, things changed dramatically, and even though U.S. stocks are near an all-time high (as measured by the total return of the Wilshire 5000 Index), the divergence between munis and Treasuries has become large.
Granted, the current correlation between munis and U.S. stocks is zero, but Treasuries have more than a -0.5 correlation. More important, when stocks cratered in 2008 and early 2009, muni correlations turned positive while the negative correlation in Treasuries increased. Part of the reason that the correlation between munis and stocks may still be low is that munis are owned by individuals rather than institutions. Individuals may be more interested in coupon payments and may not be assessing risks fully in the way that an institution may do for stocks.
Testing the theory that institutions would take into account pension risk was the subject of a research paper by Li Jin of Harvard Business School, Robert C. Merton of the MIT Sloan School of Management and Zvi Bodie of Boston University titled "Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan?" The studyexamined the pension risk of corporations and concluded that "equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions."
It would be reasonable to assume that pension risk in muni bonds should also be priced in and that this risk would increase if stocks perform poorly in the next decade. In fact, Rauh noted, "There is reason to believe that munis and stocks may become more correlated in the future."
One key purpose of a bond portfolio is to act as a shock absorber when stocks tank. In 2008, the average bond mutual fund lost 8%, while strong bonds, such as the Barclay's Aggregate Bond Index, gained more than 5%. If the fate of munis will increasingly be tied to stock performance, then the recently increasing correlations between munis and stocks will also continue. All may be well if stocks rack up great returns over the next decade or two. But if stocks have a bad decade, then it is likely muni bonds will also suffer and clients may see their muni bonds tank just when they need them the most.
Munis make up about 10% of the U.S. bond market. By comparison, about 60% of bonds are issued by the U.S. government or U.S. government agencies. For planners, this could mean that putting a high percentage of clients' bond portfolios in municipal bonds could have disastrous consequences.
If this worries you, consider limiting the size of a client's muni bond portfolio. Place taxable bonds in a client's IRA before considering muni bonds elsewhere in a portfolio. If you are considering buying individual muni bonds rather than low-cost bond funds, be careful. Consider that:
* Individual muni bonds can have bid-ask spreads of 2% to 5%. Munis trade so rarely that spreads are huge. This is the industry's dirty little secret. Go to Bondview.com and track a bond's sale and subsequent purchase price. Spreads were far larger during the financial crisis in 2008 and early 2009; this would likely happen again if perceived muni bond risk rises.
* An individual bond muni ladder provides no protection against interest rate risk. A good muni bond fund is a laddered portfolio.
* Diversification is more easily achieved with a bond fund.
Remember the differences between my warning and that of Meredith Whitney. I'm not predicting animpending disaster. In fact, I'm not predicting a disaster at all if stocks have a bullish decade. What I am saying is that municipal bonds are now far more tied to eqiuty returns than in the past. Don't count on muni bonds acting as a cushion for your clients if stocks perform poorly in the next decade.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He writes the Irrational Investor column for CBS MoneyWatch and is an adjunct instructor at the University of Denver.
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