STOCKS & BONDS


Are Municipal Bonds Still Safe Investments?

The tale of Stockton, Cal., is one of two cities: the gritty agricultural town of its roots and the cosmopolitan tourist destination that it aspired to become. But like American families who borrowed to finance a lifestyle they couldn’t afford, this northern California community is now paying a heavy price for its grand ambitions. Key city buildings are in foreclosure, and businesses have folded, leaving shuttered storefronts in their wake. Three years of municipal cost-cutting has drastically reduced serv­ices, including police and fire protection, and has helped propel the city’s per capita crime rate into the nation’s top ten. In June, Stockton became the largest U.S. city in history to file for protection from creditors under the nation’s bankruptcy laws.

SEE ALSO: How to Buy Muni Bonds Safely

Stockton has also become a cautionary tale for buyers of municipal bonds, who tend to be older, wealthier investors lured by the tax-free status of most munis. Investors, who once believed it was nearly impossible to lose money with bonds backed by the full faith and credit of a city government, are now being told that Stockton expects them to accept a loss on their investment. “Stockton makes it clear that general obligation bonds are no longer such a safe haven,” says Marilyn Cohen, president of Envision Capital Management, in Los Angeles. (General obligation bonds are those backed by an issuer’s taxing power. See our tips on how to avoid muni-bond land mines.)

Two years ago, prominent analyst Meredith Whitney predicted that dozens of cities and counties would default on billions of dollars’ worth of municipal bonds. Although that worst case has failed to materialize, Stockton is beginning to look like one of many dominos. Within days of Stockton’s bankruptcy filing, the tiny California community of Mammoth Lakes followed suit, as did San Bernardino, a vast, economically troubled community east of Los Angeles. These cities are among dozens of communities across the country attempting to renegotiate their debts, within or outside of bankruptcy, as bondholders watch nervously.

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To be sure, municipal bankruptcies are rare. Some states don’t even allow them. Defaults—instances in which a financially troubled entity fails to pay 100% of the principal and interest owed to investors—are rare, too. Less than one-half of 1% of the muni bonds outstanding fall into default in any given year, says Dick Larkin, director of credit analysis at HJ Sims, an investment firm in Fairfield, Conn. But a series of systemic problems have hiked the risk of default to levels unseen in this generation, says Doug Scott, managing director at Fitch Investors Service, which rates muni bonds. Few of these problems were created yesterday, and they are not likely to be solved tomorrow.

Overly Generous Pensions

Stockton’s woes, rooted in a string of historic missteps, are emblematic of the troubles besetting hundreds of similar communities nationwide, many of which issued municipal bonds to finance their growth. Former Stockton city manager Dwane Milnes says Stockton’s problems started with the booming stock market of the 1990s, which left public pension funds flush with cash. Money set aside in pension plans can’t be used for any other purpose. So when it came time to negotiate labor agreements with public employees, city officials agreed to boost promised retirement benefits-—which cost no cash upfront—-instead of providing rich raises. By the time the bargaining ended, the police and firefighters had landed agreements that allowed them to retire at age 50 with pensions that amounted to 3% of pay times their years of service.

That was fairly typical in California, says Keith Brainard, research director at the National Association of State Retirement Administrators. After the legislature passed a law in 1999 that allowed public-safety officers to receive these enriched benefits, city after city approved the new formula, arguing that to do less would make it impossible to compete for police officers and firefighters. Nationwide, retirement formulas were also raised, although not quite as generously. Public-safety workers typically collect 2.5% of their pay for each year they work and are able to retire by age 55, Brainard says.

For Tony Delgado, a 53-year-old former Stockton patrolman, the enriched pension promise meant that when he retired in 2009 with 28 years of credited service, he walked away with 84% of his six-figure salary. His wife, a former probation officer who was injured after less than six years on the job, gets a pension of $2,500 a month, he says. Between them, they collect more than $100,000 annually in retirement. And because they both retired so early, they could be retired for far more years than they worked. Until the bankruptcy filing, the city was also paying for all of their medical insurance. Stockton officials have told former employees that the city intends to charge them for health policies this year and cancel retiree medical coverage by next year. Otherwise, city officials have said, retiree medical costs would exceed the cost of providing medical benefits for existing employees within a year. Overall, the cost of paying pension and health benefits to retirees now accounts for nearly 18% of the city’s budget; paying wages and benefits to existing employees accounts for 50.4% of the city’s budget.

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