Municipal bond holders may not appreciate the risks they are undertaking. Municipal bonds have always been viewed as an ultra-safe investment. However, in recent years a number of pundits have predicted widespread defaults on these bonds precipitated by growing unfunded state and local pension liabilities. With some exceptions (Detroit, Puerto Rice and Stockton, CA), these predictions have not come to pass. Investors have given little heed to these warnings. Ratings agencies and fund managers in this sleepy sector continue to operate on the assumption that things will somehow work out.
The liabilities of state and local governments are now estimated at about $8 billion – half owed to bond holders and half to pensioners. Rising stock markets and low interest rates in recent years would seem to have been the perfect environment for state and local governments to improve the pension funding. However, things have continued to deteriorate making it more likely that predictions of widespread defaults may pan out. At the beginning of the financial crisis, according to the Pew Charitable Trust, state and city pension plans were on average 86 percent funded. Unfunded liabilities have now grown to $1.4 trillion and just 66 percent are funded. This is based on states’ and cities’ own rosy assumptions that future returns on pension assets will on average equal 7.5 percent.
Decreasing this assumption by only one percent increases pension liabilities by about $400 billion. Using more realistic assumptions, the American Legislative Exchange Council estimated that the funding of Connecticut, Illinois and New Jersey, the three states with the biggest challenges, is only 19.7 percent, 23.3 percent and 25.7 percent respectively. Cities can cut back on services and take on more debt without bouncing checks to pensioners or bondholders. But rising interest rates, declining stock markets and/or a recession may be the tipping point. In the last recession, state revenues across the country declined on average by 8 percent. When crunch time comes, municipal bonders may be in for a shock. In those bankruptcies to date, pensioners have fared far better than bond holders. When the municipal bond market start to reflect the real risks, bond holders will be asking why no one saw this coming.