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Making Sense: Illinois Municipal Bonds Decision Time

United States Municipal Bond
Recently, I have received calls and emails regarding Illinois. Mainly, readers are concerned that an Illinois default could lead to a contagion to other troubled states (New Jersey and Connecticut are believed to be the next most troubled states). Although Illinois has very real problems, investors and advisors need to maintain their cool. 
 
An Illinois G.O. default is not an immediate concern. However, a downgrade to junk status is. A downgrade below investment grade could lead to more price weakness. This is less from a credit weakness perspective (most market participants are already keenly aware of Illinois’ woes), but from a price perspective.

 Putting investors out of the market

Some investors and portfolio managers cannot own junk-rated municipal bonds. A downgrade to junk status may force some investors and portfolio managers to sell Illinois bonds into an already soft market. This could drive down prices further. The corresponding rising yields would result in higher borrowing costs for the “Land of Lincoln.”
United States Municipal Bond
 
Given the trouble in Puerto Rico, investors are asking if Illinois is a redux of the troubled commonwealth. I don’t think so. Illinois’ economy is still robust. Most of the State’s woes come from a lack of spending control and generous other post-employment benefits (OPEB), such as pensions and healthcare. The state legislature and the governor have the potential to right the fiscal ship, if they are willing to make painful changes.
 
Investors and advisors need to understand that not all “Illinois” municipal bonds are in peril because of fiscal difficulties at the state level. For instance, a local water, sewer or sanitation revenue bond would be isolated from troubles with state debt and need to be judged on their own merit.. Some fear-mongers have hypothesized that G.O. bondholders could push the State to claw-back revenues to pay G.O. debt, leaving revenue bonds vulnerable to default. Although this is not easily done, I would be foolish to rule out a clawing-back of state revenues. 

 Where is revenue coming from?

The State of Illinois clawing back local revenues would be, in my opinion virtually impossible. Local debt, whether G.O. or revenue, is not at obligation of the state. This would be like my clawing-back your income to pay my debt. However, in the current environment where fixed income information and guidance is scarcer than at any time in my career, we could see a situation in which investors simply sell “Illinois” bonds without understanding the difference between the babies and the bathwater. 
 
As for contagion to other troubled states, such as Connecticut, New Jersey and, even, Pennsylvania, this is possible from panic selling standpoint, but I doubt a potential Illinois default would embolden other states to default on their state G.O. debt. However, municipal bonds tend to be a very retail-centric asset class. Retail tends to overreact and often sells bonds without fully understanding what they own. Thus, we could see a scenario in which investors sell local essential service revenue bonds because the state in which they exist is experiencing trouble.
 
The way I would approach investing in troubled states is, where in clients’ best interests:
 
Avoid appropriations bonds (which rely on annual funding votes to remain solvent) and pension bonds. Focus on essential service revenue bonds, particularly on the local or county level. For investors considering junk bonds, anyway, they may wish to consider the state G.O. debt of troubled states. Remember, one must do one’s credit homework before purchasing any municipal bond. One also must be honest with oneself and with one’s financial advisor regarding credit risk tolerance. One does not want to get cold feet when volatility arises as it might cause investors to panic and sell at an inopportune time. Not being honest about credit risk might also result in dealing with a credit default that one is not truly capable of enduring. 
 
As always, I am happy to review any and all bonds for subscribers.

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About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.
Twitter: @Bond_Squad
E-mail: Thomas.byrne@wsandm.com

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Thomas Byrne

Thomas Byrne serves ad the Director of Fixed Income for Wealth Strategies Management LLC. Thomas brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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