Morningstar Advisor - August/September 2013 - (Page 41)

anticipating too much revenue and accumulating too many liabilities. Taken together, these factors combined to create a sense that credit quality in the muni market was strong and that credit analysis was somewhat superfluous. Cracks in a Safe Haven The 2007–2008 crisis, of course, changed all of that. By the end of 2008, assumptions about relative yields of municipals to Treasuries and the unassailable strength of the bond insurers and their AAA rated credit were no longer valid. In Washington, D.C., legislation that passed in February 2009 contained a number of significant provisions designed to support the muni market. As the year unfolded, normalcy slowly returned to the muni market. That year saw the first Build America Bond issues come to market in what would turn out to be an incredibly popular issuing vehicle for taxable muni debt. Over the course of 2009 and 2010, taxable municipal issuance from this program hit nearly $200 billion. While there was still a great deal of uncertainty facing investors in the muni market, particularly from the risks posed by economic and real estate market weakness, by the fourth quarter of 2010 the worst seemed to be over. Alas, it wasn’t. In the second half of 2012 there was a renewed focus on credit risk. In the summer, over a span of just a few weeks, three California issuers declared bankruptcy: Stockton, Mammoth Lakes, and San Bernardino. The filings gave pause to the calm of the market. California had handled municipal bankruptcies before. In 2008, Vallejo, Calif., declared bankruptcy, but all debt service payments were made on time and the city exited Chapter 9 four years later. The cause of Vallejo’s trouble—untenable employee wage contracts—did not seem to be a systemic problem that would spread to other towns. Municipal Messes: Notable recent defaults and bankruptcies. Municipality Event Date Jefferson County, AL Notice of Default 7/30/09 Jefferson County, AL Filing for Bankruptcy 11/9/11 City of Stockton, CA Filing for Bankruptcy 6/28/12 City of San Bernardino, CA Filing for Bankruptcy 8/1/12 City of Detroit, MI Emergency Manager Appointed 3/6/13 City of Detroit, MI Interest Payment Delinquency 6/15/13 Detroit by the Numbers: The Motor City’s financial woes are evident from a few key statistics. $19 billion Detroit’s current debt obligation. –26% The drop in Detroit’s population since 2000. 78,000 Number of vacant structures in Detroit. 40% The percentage of Detroit’s 88,000 streetlights that don’t work. 18.3% The city’s 2012 unemployment rate. 982 Acreage of Belle Isle park, which the city could sell to raise cash. $246.5 million Amount of uncollected city property taxes in 2011. By contrast, the Stockton and San Bernardino situations appear to present a more general danger. In both cases, the cities are part of the California “Inland Empire,” where the economic and housing booms that preceded the crisis were strong. In both cities, property values plummeted and unemployment increased dramatically, placing intense stress on both revenues and expenses. There are two aspects of these cases that bear closer examination. In the case of San Bernardino, the city chose an expedited route to filing, and there are some who question whether the city met the necessary tests for taking the path it chose. This case has yet to come before a judge. In the case of Stockton, there is a clear conflict of interest between bondholders and the pension plans that cover city employees. This aspect of the filing has potentially grave importance for bondholders and pension beneficiaries across the nation. In preliminary rulings, the judge in the case has rendered an opinion that does not lend clarity to which group has primacy of claim. Other Factors to Watch Detroit’s situation and the California bankruptcies aside, there are other factors that could weigh on municipal bonds. Like in all debt markets, the role of the Federal Reserve and the level of interest rates in the economy directly impact holders of muni bonds. A rise in rates will result in lower values for outstanding bonds held while offering higher levels of income for new investments that have been available for the past few years. Another significant development could come in the form of tax reform, oft mentioned but rarely enacted. Not since the Reagan administration has the muni market faced a significant rewrite of the tax code. A number MorningstarAdvisor.com 41 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2013

Morningstar Advisor - August/September 2013
Contents
Contributors
Letter From the Editor
Under Pressure
Has Your View of Bonds Recently Changed?
The Simple Life Cuts a Path to Prosperity
How Extended Is Your Bond Fund?
A Bond Contrarian Scours the Globe for Value
Investments á la Carte
Investment Briefs
Bond Market Behemoths
Shopping in the Digital Age
Shopping in the Digital Age
Diverse Crowd
Motor City Meltdown
Bond Convergence
Corporates Are Fairly Valued, but Opportunities Will Arise
A Legend Still Pines for the Good Fight
Greener Pastures
Forecasting Market Bubbles and Crashes
Forecasting Market Bubbles and Crashes
Home-Court Advantage
Overcoming Technophobia
These Funds Are Counting on Undervalued Sectors
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
What Price Advice?

Morningstar Advisor - August/September 2013