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When strictly analyzing the default risk of your investment holdings, municipal debt is often regarded as one of the safest forms of investments – compared to corporate debt – because municipal bankruptcies are a rare occurrence in the United States.
This also means that municipal debt investors often spend more time analyzing other risk and intricacies of municipal debt like interest evaluating rate risk, comparing taxable and tax-free returns, and comparing revenue vs GO debt instruments. However, the number of recent municipal bankruptcies reminds investors to stay vigilant of the municipal default risk when making their fixed-income investment decisions.
In this article, we will take a closer look at the recent municipal bankruptcies, any commonalities, and what investors should look for before making their investment decisions.
Be sure to check out our Education section to learn more about municipal bonds.
Although municipal bankruptcy is often the end result of decade-long financial mismanagement, lack of financial preparedness and/or political decision-making at the local government level, a financial downturn is often the leading contributor.
Prior to the 2008 downturn, things looked very different for all local governments throughout the U.S:
1. The stock market was booming, enabling local governments to earn high returns on their pension portfolios.
2. The real estate market was hot, increasing property tax revenues.
3. Consumer sentiment was at an all-time high, bringing significant growth to sales tax revenues.
The annual budget document can be a great tool when analyzing the financial strength of municipal bankruptcy. This is a forward-looking document that highlights the expected revenues for the next year, expected/budgeted expenditures and further allocation of funds to different areas of the municipality including police, fire, community services, etc.
Out of these two variables – revenues, and expenditures – local governments have very little control over the revenues as they are often generated by the tax base of the respective government. For example, two of the main sources of revenues for local governments are often sales tax and property taxes. Where sales tax revenues are based on consumer spending, property taxes are based on the property values within the jurisdiction – making them extremely sensitive to a financial downturn in the local state of national economies.
Let’s take 2008’s financial collapse as an example: the recession wasn’t unique to one or two areas of the financial markets, but it had an impact on every single area of the economy, from jobs to employers to property values, almost every area of the economy took a severe hit. In such times, it’s expected for employers to lay off employees, wages to be cut and, ultimately, for consumers to spend considerably less money. Consequently, low consumer spending directly results in low sales tax revenues for local and state governments.
The same logic can be applied to property tax revenues. In the 2008 recession, the property tax values were slashed nationwide, and because the property taxes are a percentage of your property value, this ultimately impacted the property tax revenues for local governments. For example: In California, if the average price of a single-family home was $350,000 prior to 2008 recession, and the property tax rate was 0.77% of the assessed property value, this would’ve generated a property tax bill of $2,695 annually. Post-2008, if the same house value was slashed to $200,000, the property tax bill would’ve been $1,540. This decline in property tax revenues can lead to serious financial strains for the local governments.
Now, looking at the budget book, if your revenues are slashed, but your expenses remain the same – you will create serious imbalance in the budget. During the recession, many governments started cutting their expenditures, which included laying off employees, cutting services, and, in some cases, raising taxes. Furthermore, the expenditure cuts to police and fire services fostered higher crime rates in some communities, which further worsened problems, and some communities are still struggling to emerge unscathed from them.
Dont forget to check out our take here on understanding the comprehensive annual financial reports (CAFR) as reported by your local, state and other government entities.
A long-range financial plan is not only a fancy document that’s reserved for financially sound cities to deploy – but something all local governments should engage in.
Take the case of San Bernardino – a city already struggling with high employee and leadership turnover – that had antiquated labor contracts which were neither financially sound nor responsible. Moreover, prior to the bankruptcy, over 70% of the city’s budget was allocated toward police and fire services. The assessment of whether a locality is overconsuming fire and police services relative to what it can afford is particularly salient in San Bernardino.
For generations prior to the bankruptcy, a city-charter provision had mandated that police and firefighters be paid the average of salaries in ten other like-sized cities (population from 100,000 to 250,000). Most comparison cities were in a far better position fiscally to pay those salaries, however. Post the city’s bankruptcy, a citizen commission advised that the city will need to end the average salaries’ provision for its police and fire employees. The recommendation also advised this mandate to be replaced by collective bargaining.
As mentioned earlier, high crime and inadequate law enforcement manpower will keep any local government struggling to come out of its financial ruin. Not only that, you will eventually see a constant decline in the population – as people will move out of the area seeking safety.
This was the case for Detroit, MI. According to the U.S. Census data, the year 1950 recorded the highest population for the city at 1.9 million residents. This number has declined over the years and during the year the city filed for bankruptcy, its population was merely 690,000 – a 63% decline.
This decline in population led to a smaller tax base and served a detrimental blow to the city’s overall revenue sources.
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After some of the well-known bankruptcies of U.S. municipalities, more and more local governments are breaking the monotony of simply following their revenue and expenditures and turning toward building a sustainable framework of long-range financial strategy to make expenditure decisions over future budget cycles.
This strategic financial planning for municipal governments can send a strong message to municipal debt investors and others about the municipality’s financial preparedness. If an investor is comparing two different municipal debt issuers for their potential purchase of municipal debt, given financial indicators being equal, a strategic plan can highlight the proactive approach of top management and long-term commitment towards their institution.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.