Gauging the Spook Factor for Municipal Bond Investors by Michael Brooks, AllianceBernstein

The muni market seems to be returning to normal after major outflows last summer, though several potential hot-button issues could still spook investors. We don’t think these represent major risks to market returns or properly positioned portfolios.

Fear of Rising Rates: Last May, the US Federal Reserve announced it was considering tapering its security purchases. Investors took it as a sign that rates would soon rise; many of them bailed out of the market. In one month, they pulled more than $16 billion out of municipal bond mutual funds, and five-year AAA-rated bond yields jumped from 0.80% to 1.60%. By the end of the year, net outflows totaled over $65 billion.

But in December, when the Fed finally announced that the phase-out would begin in January, the market yawned. The most skittish investors were gone, and those who remained were less concerned. It’s unclear how the remaining muni investors will react when the Fed starts raising rates. We expect some reverberation, but likely less extreme now that the most fearful investors are gone.

Puerto Rico Outlook Remains Bleak: Puerto Rico’s economy continues to contract, and we don’t see a future engine of growth. We expect jarring news for many Puerto Rico Electric Power Authority investors early next year, when restructuring talks begin in earnest. It’s unlikely this issue will drive down general demand for munis, since market expectations for Puerto Rico are already very low.

Could Chicago Be the Next Detroit? Detroit’s population has shrunk dramatically over the years, while Chicago’s population has been relatively stable. So why have Chicago’s credit ratings dropped sharply over the last year?

Finances. For many years, Chicago has spent beyond its means and hasn’t provided enough funding for its pension obligations. As a result, the city requires a dramatic increase in funding. When combined with debt service and other fixed costs, pension costs could take up 40% of Chicago’s budget. Addressing the resulting hole in the budget will be difficult and controversial, and bankruptcy may even be raised as an option, although we doubt it will go that far.

Illinois Faces a Budget Shortfall: Illinois suffers from the same problems as its largest city. But it has the resources to fix them. The most urgent issue is that the temporary increase in income taxes from 3.75% to 5% enacted several years ago is scheduled to phase out in January. The higher tax rate helped Illinois pay its bills, and the state really can’t afford the drop in revenues if the tax rate falls.

However, both the incumbent Democratic governor and the Republican challenger have indicated that they intend to ask for an extension of the higher tax rates in order to balance the state budget. We expect the legislature to act during a five-month period starting in January, when the vote required to do so drops from a supermajority of 60% to a simple majority.

Pension Contracts Are Being Renegotiated in Court: Because there have been so few municipal bankruptcies, there’s little precedent for how Chapter 9 laws apply. Last year, only seven municipalities, including Detroit, went this route, out of 90,000 units of government in the US.

One of the most important unsettled questions is whether pension liabilities can be treated like any other contract. The main argument against this notion has been that state constitutions protect retirees’ pension benefits. But in the recent Detroit and Stockton, California, cases, judges have indicated that pension benefits are a contract between the municipality and the employee, similar to collective bargaining agreements. So, some judges have ruled that once a municipality is in bankruptcy, pension benefits can be reduced.

The law isn’t settled, but the direction seems clear. We could see more municipalities filing for bankruptcy to deal with serious fiscal problems. Or, more likely, struggling municipalities may use this chip in collective bargaining agreements as leverage to address their financial troubles sooner rather than later. This would increase the recovery rate for long-term creditors.

Any of these issues could push some skittish investors to start selling, hurting municipal bond prices. But we don’t think any of the developments should shake investors’ confidence in the overall health of the municipal market.

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.

Michael Brooks is a Senior Portfolio Manager for Municipal Investments at AllianceBernstein Holding LP (NYSE:AB).

Gauging the Spook Factor for Municipal Bond Investors