What does it mean for investors when a city, country or territory declares bankruptcy? When placed in the context of the thousands of government entities in the U.S., it is an infrequent occurrence. When it does happen, however, it certainly grabs our attention. It is a reminder that municipal bonds, like all bonds, carry some risk.
Hundreds of bankruptcies by municipalities have been recorded since the 1930s. The largest ever municipal bankruptcy occurred in 2013, when the city of Detroit filed for Chapter 9 protection from creditors. The troubled city, with a declining tax base, was unable to meet all of its financial obligations and required a restructuring of its debt. Other cities—such as Chicago and Atlantic City, New Jersey and the territory of Puerto Rico—are facing financial challenges that have put them in recent headlines.
In the case of Detroit’s bankruptcy, the city’s declining economic fortunes resulted in a notable drop in its tax collections. Other governments have run into problems due to overwhelming pension obligations, financial mismanagement, or various other problems that created a budget crisis.
A reality check about debt
issuers
Individuals often choose to invest in bonds in order to generate a stream of income on a regular basis. In essence, investors are lending money to the bond issuer, who promises to pay back the principal, but in the meantime, makes interest payments to the investor. Municipal bonds are particularly attractive to some investors because income is generally free of federal income tax, and sometimes state and local income tax as well.
Any bond carries risk. One of the most important that investors must consider is the possibility that the issuer will default on debt securities that were sold to investors. Generally, investors tend to think that there is little likelihood that a government entity that issues a bond will default on its obligation. After all, a municipality or other government unit can issue bonds that are backed by its authority to levy taxes on citizens. But this does not preclude the potential for the municipality to run into a financial shortfall.
The fact that municipal bankruptcies occur for a variety of reasons and through different economic climates indicates that taxing power alone will not fully protect investors. Bankruptcy courts will often require these government entities to take steps to improve their financial standing, including selling assets as a way to raise money to help pay creditors.
Municipal bonds may work for the right investor
Most investors view bonds as an asset class that potentially carries less risk than some other types of assets, such as stocks or commodities. Bonds also tend to perform differently in various market environments than asset classes like stocks. Bonds can therefore play an important role in diversifying a portfolio. That type of diversification may be a valuable benefit for investors, and municipal bonds can play a role.
While a municipality may run into financial difficulty, its bonds can remain attractive. Some investors view the unique ability of these bonds to provide income that is generally free from federal income tax (and sometimes from state and local income tax) as being worth the risk. While you consider your options in the bond market, work with a financial professional who can help you to determine what investments make sense in the context of your portfolio and financial goals.
Brandon Miller, CFP is a financial consultant at Brio Financial Group, A Private Wealth Advisory Practice of Ameriprise Financial Inc. in San Francisco, specializing in helping LGBT individuals and families plan and achieve their financial goals.
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