02/18/2010

In these perilous economic times, we toss around terms related to bankruptcies – Chapter 7, Chapter 11, Chapter 13.  But honestly, who has heard of Chapter 9? If you hold municipal bonds in your portfolio, Chapter 9 could be looming on your investment horizon.

Chapter 9 – horror of horrors – is reserved for the bankruptcy of municipalities—that is, towns, cities, villages, counties, universities, library and school districts, well, all local taxing authorities. You know, all those bond referendums we vote for/against related to virtually all forms of local governance, it is all debt. The debt is sold to investors who want a pretty sure thing at a decent interest rate, given the fact that all interest earned could be totally tax free. Who are those investors? Me, for one. And you may be holding muni bonds, too, either as actual bonds or in a bond fund. Munis, especially Triple A munis, have been considered pretty safe and pretty certain for a lot of years. You can get a bigger face value bang for your buck with corporate bonds, but if you want to be relatively sure that your investment won’t evaporate, then the general rule has been “go with a muni.” And these days, the yield on tax free munis looks pretty attractive, too.

Here is the problem – local taxing authorities rely on tax revenues to pay the daily bills AND service the bond debt. When people who live in the locality lose jobs, they stop buying things (no sales tax) and start defaulting on their mortgages (no property tax collections) and suddenly the local taxing authority is less solvent and less able to meet its obligations – like the interest on bonds and the repayment of principal on those bonds. How often does this happen? Good news – almost never. But if you are a Boomer, you will recall that Orange County California went broke in the mid-90s and a lot of people lost their life savings and pension plans as a result of the collapse. And what about New York City back in 1975 – bailed out by a loan from We the People?

So here is the skinny on Chapter 9. Created during the Great Depression (surprise!), it protects an insolvent municipality/local taxing authority from its creditors (ie current bond holders are creditors). It is NOT a liquidation, but a reorganization. The municipality puts together a plan to adjust debts (bonds) and can do so by lowering interest rates, securing new debt, and extending debt maturities. Included in the plan are the strategies to emerge from bankruptcy – like controlling costs, cutting services, raising taxes, all wildly unpopular, but necessary to balance the budget and get back onto a stable footing.

So, where does that leave you, the bond holder, if a municipality is teetering on bankruptcy and defaults on a bond? If it is insured, then you probably won’t miss a payment. If your bonds are not insured, then there could be a problem – you may or may not ever get paid. If a municipality seeks bankruptcy protection, your debt may be restructured or even called – that is, you will receive the principal or most of the principal, end of story. If you don’t get it all back, the difference is deductible as a capital loss on your tax return.

Now for the flip side: where there is great risk there may be great reward. Note : “may.” Munis have relatively high yields these days because they are becoming riskier investments. Proceed with extreme caution and a strong and optimistic stomach. Understand your risk tolerance. And understand what your investment is – where are the funds coming from to service the debt? Is the bond rated Aaa and is it insured? Or will you sleep better if you cash out your munis and stuff the money in your mattress?