In theory, the financial woes plaguing a few cities should be calamitous for the bond market. In practice however, investors know better.
For as much publicity as has been heaped on the failure of cities such as Stockton and San Bernardino, and the ongoing funding concerns faced by California, Illinois and other states, the vast majority of investors maintain a healthy perspective on the fundamentals of successful bond investing – and with good reason.
In Illinois, for example, where the state’s myriad fiscal difficulties are well documented, investors earlier this month snapped up $1.5 billion in debt issued to repay a federal loan. The bonds were backed by a dedicated stream of unemployment insurance taxes and rated “AA+” by Fitch Ratings and “AA” by Standard & Poor’s. Investors placed about 10 times more orders than there were bonds available, which “has never happened before to my knowledge,” John Sinsheimer, Illinois’s director of capital markets, told The Wall Street Journal.
Similar sales in other states, such as Colorado and Michigan, have also been well received by investors.
In fact, so far this year, there have been $28 billion of net inflows into muni bond funds, according to Morningstar. Although the year is only 7 months old, that figure represents the second-best total since 1993. Since mid May, the average flow into muni funds has been about $900 million a week.
Scary stories aren’t deterring investors
The enthusiasm for munis would seem to run counter to the dire warnings sounded in the media, but is consistent with the facts.
Investors realize that defaults in the $3.7 trillion muni market are extremely rare and confined, for the most part, to certain special situation issues. Even among the recent failures that attracted so much attention, a simple analysis of how bondholders were actually affected would tell a very different story than the headlines would suggest (see “Most Stockton Bondholders Unaffected by Bankruptcy”).
Of course, muni investing, like all investing, is not without risk. Some local governments face genuine fiscal challenges that can have dire consequences if not addressed. Fortunately, there are signs that once seemingly intractable attitudes are changing and concrete steps are being taken to wrestle with long-term fiscal threats (see “Pension Reform: A Welcome Sign for Bondholders”).
Clearly, investor appetite for muni bonds hasn’t been dulled by recent problems facing a few isolated cities. In fact, with negative real returns in money funds and continued volatility in the equity markets, the advantages of a steady stream of tax-free income have never been more appealing. Our mantra remains the same: Be discerning. Look for quality, first and foremost, and the news reports won’t keep you awake at night.