Worried about bonds and bankruptcies?

Source: MARKETWATCH

By Robert Powell, MarketWatch

Last Update: 12:01 AM ET Aug 1, 2012

BOSTON (MarketWatch)Its not as if there arent any local government bonds to invest in these days. But the listespecially in the wake of recent of bankruptcy filings in Californiais seemingly getting shorter, the number of questions about such bonds is getting longer, and the job of figuring out which municipal bonds to consider as well as avoid is getting all the harder.

To be fair, theres actually a fairly long list of local government bonds in which to invest. To wit: the local government sector consists of more than 89,000 units including municipal governments, townships, counties, school districts and special districts, according to a just-published report from members of the BlackRock Municipals Group.

And most of those units havent filed for bankruptcy, according to Peter Hayes, the head of the BlackRock Municipals Group. In fact, there have been only 45 Ch. 9 bankruptcy filings since 2007, according to Municipal Market Advisors. And of those 45, nearly 40% have occurred in either California (8 out of some 4,000 local governments) or Nebraska (11), Hayes wrote the report.

For the record, Hays said, its been somewhat clear that local governments would be more exposed to bankruptcies and defaults than states and other portions of the municipal market, for several reasons. For one, locals can file for Ch. 9 bankruptcy protection. Plus, the housing boom and bust has led to falling property tax collections. And, local governments have substantial fixed costs, which are hard to fund when revenue is falling. Add those and other reasons together and you get the current state of affairs.

In fact, the recent bankruptcies in CaliforniaStockton, Mammoth Lakes and San Bernardinohave caused quite a stir. And that has investors in the municipal market questioning the fiscal integrity of issuers and trying to discern whether events in the most populous state represent the beginning or the end, an anomaly or the mean, Hayes wrote in his report.

Recent events in California notwithstanding, most of the 45 filings since 2007 were not cities, Hayes wrote. In Nebraska, for instance, the bankruptcy cases were primarily very small development districts that were typically nonrated and, as such, speculative in nature.

And outside of California and Nebraska, no other state approaches these numbers. This tells us that the vast majority of the country has been able to manage its debt and presents opportunity for investors, Hayes wrote.

Opportunities yes. The less difficult task, however, is finding the local governments to avoid. According to Hayes, the signposts BlackRock looks at when assessing local hardship are high levels of foreclosure, unemployment and poverty, as well as out-migration population trends and, most importantly, fiscal mismanagement. Fiscal emergencies are another telltale sign, he said in an interview.

For instance, Hayes wrote that foreclosures were most acute in areas that saw soaring home prices such as Southern California, Arizona, Nevada, and Florida, as well as older industrial areas such as Ohio and Michigan. As such, it is fairly easy to identify areas that are more susceptible to fiscal stress, Hayes wrote. In modern-day ghost towns (former booming areas struck by high foreclosures), there are undoubtedly certain municipal credits that should be avoided.

Consider too what Hayes calls the margin of safety. Look for less obvious signs of financial distress, such as how often does an issuer access the short-term market? Does the issuer have to fund deficits in this way? And consider what Hayes refers to total liability management. Determine whether issuers are inclined to pay as they go (do they meet debt obligations in the present?) or kick the can (do they defer financial obligations to the future?).

Another sign to watch for is the degree to which states will intervene in a local governments financial affairs. Some, such as Pennsylvania, Rhode Island, and Michigan, are proactive while California is taking a more hands off approach, said Hayes.

The goal is to anticipate what may happen before it actually does, Hayes wrote.

Here, by the way, is a map that illustrates areas BlackRock believes are vulnerable to fiscal distress and potential bankruptcy/default, as well as those areas representing greatest opportunity.

As you can see, local governments to avoid would include those in the agrarian exurbs in California; the so-called boom-bust housing triangle in Nevada and California; Florida; Georgia and Alabama (which have a limited tax base); the upper Midwest; and southern New England.

For his part, Jeff Augustine, of Augustine Financial Solutions, noted that pressure on high-yield municipal deals, such as those in California and Nevada, means that the yield spread between high grade and lesser quality issues could widen. This would depress prices of high-yield muni bonds and muni bond funds, all else constant, said Augustine. Even if investors want to take high-yield muni risk, it should be in an appropriate allocation vis--vis their risk tolerance.

As for where to invest, BlackRocks map seems to suggest that you consider investing in local governments in parts of Texas, Colorado, Virginia, Wisconsin and Minnesota.

The key, of course, to municipal investing, said Hayes, is credit research. The current environment only reinforces that view. Choosing high-quality, high-potential investments requires a deep understanding of individual credits, issuers and the economic, social and political environment in which they exist, he wrote.

Augustine is of the same opinion. Stay with high-quality securities that are essential service revenue bonds or general obligations or GOs, said Augustine. And with respect to GOs, the states have the greatest flexibility since their taxing authority is not limited by the federal government.

Still, Augustine said headline risk is a part of many investments today, and municipal bonds or bond funds are no exception. A discipline of diversification within the portfolio is key, said Augustine.

Hayes agreed that diversification is important. He also noted that investors have to understand the trade-off that exists when investing in municipals. Highly rated municipals tend to trade with fairly low yields.

As for the future, Hayes said investors need not get overly worried by any uptick in bankruptcies. While negative headlines may continue and the number of local names declaring bankruptcy could inch up from historically low levels, the total dollar amount of defaulted debt is likely to remain modest, Hayes wrote. This is an important distinction, as it speaks to the fact that many of the local filings represent very small issuers with minimal debt outstanding and, as such, have little to no impact on the broader municipal marketplace.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Follow his tweets here.

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