General Obligation Bonds Were Never Risk Free
You may have seen an article on the front page of The New York Times business section on December 23, “Bankruptcy Filing Raises Doubts About a Bond Repayment Pledge”. In our view, it is inflammatory. Below, my colleague Joseph Rosenblum offers a more balanced approach.
The article’s basic thrust is that the bankruptcy filing by Jefferson County, Alabama, raises, for the first time, questions about the full faith and credit of a municipal general obligation bond. The implication is that such bonds offered guaranteed repayment and that when Jefferson County stops payment, bondholders will be in for a surprise.
While municipal bankruptcies are extremely rare, general obligation bonds are not—and never have been—risk free. No one should expect general obligation bonds to be guaranteed in bankruptcy or expect a municipality to raise taxes to whatever level is needed to repay its general obligation bonds.
In fact, Chapter 9 of the US bankruptcy code provides a mechanism for a municipality to work out its problems. It includes a plan that might mean less than full repayment. There is a history of such events, although it is limited.
It will be up to Jefferson County, with some input from creditors and the judge, to decide how it wants to treat its bondholders. They can opt to repay the bonds in full or in part, or to stretch out repayment over time. Clearly, the county will need to bear in mind that it will need to return to the markets at some point in the near future.
The credit quality of general obligation bonds, as a class, remains quite high because most state and local governments are required to balance their budgets every year. Most state and local governments have made progress in addressing their budget shortfalls in recent months.
While there are large differences in how state and local governments are handling their financial difficulties, we expect the volume of defaults in the municipal bond market to remain extremely low.
Weak tax revenues may, however, continue to raise investor concerns about the credit quality of some municipalities, putting downward pressure on their bonds. As a result, we believe it makes sense, in the current environment, to underweight state and local general obligation bonds and overweight revenue bonds.
As we have written before, revenue bonds tend to hold up better than general obligation bonds in a weak economy because revenue bonds are backed by fees for essential services such as electricity and water. However financially pressed, the vast majority of people continue to pay their water and electric bills. Thus, the revenues that back these bonds are less sensitive to the pace of economic growth than the property, sales or income taxes that back general obligation bonds.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.
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Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income and Joseph Rosenblum is Director of Municipal Credit Research, both at AllianceBernstein.