Are Municipal Bonds Getting Riskier?

As bond insurance shrinks and retail investors start moving to stocks, could municipal bonds start finding fewer takers?

After a series of bond downgrades over the last two years, Standard & Poor's Ratings Services dropped its rating on Assured Guarantee, the last of the bond insurers -- also known as monolines -- to enjoy a AAA rating, to AA+ last week. On top of that, municipal bond insurance has been declining drastically.

So-called enhanced bonds, which are protected by insurance or letters of credit, made up nearly half (46.7%) of municipal bonds in 2007 but had shrunk to a mere 8.7% by 2009, according to a new study by Christine Martell, an associate professor at the University of Colorado at Denver's School of Public Affairs, and Robert Kravchuk, a political scientist at the University of North Carolina.

Comparable figures for 2010 aren't yet available, but Kravchuk says in an interview that it doesn't look like monoline bond insurers are reentering the market "in any significant way." Says Martell: "What you are likely to see is segregation of the market," because the highest-quality issuers don't need insurance, while lower-quality issuers do.

Incinerator Insolvency

One cautionary tale has come from Harrisburg, Pa., where an expensive trash incineration project -- funded by bonds -- has helped drive up debt. The city has run out of money and is considering bankruptcy, and has asked the state for help. The news has brought another level of trepidation to the bond market as investors wonder if they'll get paid.

But in most cases, even when cities have gone bankrupt, investors in general-obligation bonds -- which are guaranteed by municipal taxes -- haven't lost money. Robert Doty, president of municipal adviser American Government Financial Services, points out that when Orange County, Calif., entered bankruptcy court protection in 1994, holders of general-obligation bonds recovered 100% of their funds. In California, "by virtue of its constitution, debt service gets a top priority," he says. "The general-obligation bonds of the state of California are very secure."

And Miriam Sjoblom, associate director of fund analysis at Morningstar, says extreme circumstances, like municipal bankruptcies, are the exception rather than the rule. "The problems with Harrisburg, for example, are years old," she says. "The incinerator plant has been in trouble for any years, since well before the current downturn."

Sponsored Links

Of course, some bonds are riskier than others. Take those Nevada issued to help finance the Las Vegas Monorail, which explicitly stated that bond payments would come only from system revenue. This type of "revenue bond," funded by user fees, can be more speculative than general-obligation bonds -- and present a more serious risk, Doty says. The monorail, for example, filed for Chapter 11 protection in January. But even within revenue bonds, some well-established ones are "quite secure," he says.

A third type of muni bond, called special-assessment bonds, are payable from the general fund, but aren't as secure as general obligation bonds. In this area, too, investors who aren't sufficiently wary can get burned. For instance, when Vallejo, Calif., filed for bankruptcy protection and adjustment of its debts in May 2008, "those investors holding bonds payable from general funds took a hit," Doty says. Such bonds "should be considered as relatively secure, but they warrant a closer look" than general-obligation bonds, he adds.