What Happens When a Government Entity Goes Broke? [TAIO]

[I]AUG 26 2015[/I] | BY [COLOR="#000080"]STAFF[/COLOR]

[QUOTE][IMG]https://thealertinvestor.cdnist.com/wp-content/uploads/2015/08/city-broke.jpg[/IMG]

When investors buy municipal bonds, they’re essentially loaning money to local governments, school districts, other public agencies or their conduits. As with any loan, there’s always a risk that the borrower won’t be able to pay either the interest or principal on the loan – an event known as a “default.”

Puerto Rico, which has struggled for years with a slowing economy and large debt burden, made the news this summer when its Public Finance Corporation (PFC) defaulted on a $58 million principal and interest payment due August 3, 2015.

But the commonwealth is hardly the only local government to run into financial trouble in recent years. While Puerto Rico cannot declare bankruptcy ­­­­– a situation several bills in Congress have proposed changing – a wave of local governments, including Detroit, Stockton, California; Central Falls, Rhode Island; and Jefferson County, Alabama – have done just that.

Bankrupt public issuers don’t always default on their debt, and municipal bankruptcies remain rare, but bondholders have absorbed losses in several recent public bankruptcies. Thus, if you own individual municipal bonds or invest in municipal bond funds, it’s important to know whether you might be affected by serious financial trouble brewing in a town, school district, or public utility.

[B]Puerto Rico: Are You Exposed?[/B]

In recent years, Puerto Rico’s bonds have been popular among investors because they pay relatively high interest rates and are exempt from federal, state, and local taxes, according to Steve Joachim, executive vice president of Transparency Services at the Financial Industry Regulatory Authority (FINRA), which collects and publishes financial market data, including information about transactions in fixed-income markets.

In fact, some 52 percent of open-end bond funds in the U.S. have some exposure to Puerto Rico debt, ranging from 1 percent to nearly 50 percent of holdings, Morningstar senior research analyst, Elizabeth Foos, said in a recent interview.

Perhaps surprisingly, a number of funds that an investor might assume only invests in a single state actually have a significant portion of their holdings in Puerto Rico bonds, including one fund that calls itself a Maryland bond fund but for which Puerto Rico debt makes up nearly 49 percent of total assets.

Investors can determine their exposure by looking up the prospectus of the bond funds they’re invested in through FINRA’s Fund Analyzer or the SEC’s Edgar. Investors can also reach out to their broker or financial advisor to discuss any potential exposure. Investors can also find more information about individual bonds at the Municipal Securities Rulemaking Board’s database Electronic Municipal Market Access, or EMMA.

[B]How Does Default Impact Your Portfolio?[/B]

A default’s effect on a portfolio can vary widely depending on the level of exposure you have to the defaulting entity, the legal protections a specific bond issue carries, and whether it is insured.

Some municipal issuers purchase bond insurance, which means an insurance company would cover interest and principal payments if the municipality or obligated persons failed to pay investors when due.

How much bondholders ultimately recover typically depends on several factors. In general, however, when an issuer defaults investors who own its bonds will either receive their interest and principal payments late or receive less than they expected. The value of those bonds, should an investor look to sell them, is also likely to decline dramatically leading up to an anticipated default, and in the immediate aftermath of an actual default (though that value can eventually rebound over time).

Investors who own mutual funds that invest in municipal bonds have different concerns. Mutual funds distribute the interest payments they receive on bonds to shareholders. If defaulting bonds make up a portion of the fund’s assets, an investor might not notice a big difference in their income distributions.

But if a bond fund is heavily invested in bonds that either default or are in danger of defaulting, the fund’s market value could fall as the prices of the underlying bonds decline.

[B]What About Municipal Bankruptcy?[/B]

A default isn’t the only municipal fiscal crisis that can affect a bondholder’s portfolio. Bankruptcy can have serious implications, too.

Municipal bankruptcy plans must consider obligations to former employees who are collecting pensions and the municipality’s need to continue to serve its constituents in addition to what is owed to bondholders. They also look at operating deficits and requirements for a balanced budget.

In two recent bankruptcies – Detroit and Stockton – bondholders have been forced to take losses. Detroit’s approved bankruptcy plan, for example, stipulated that holders of general obligation bonds would receive only 74 cents on the dollar, according to Bloomberg. Investors who held limited-tax bonds, which are backed by specific streams of tax revenue, would receive just 34 percent the of $164 million that they are owed.

[B]How Does Municipal Bankruptcy Work?[/B]

Municipalities, a designation that includes towns, cities, villages, counties, school districts, and public authorities, that issue debt have been eligible to declare bankruptcy under Chapter 9 of the U.S. bankruptcy code since 1934, state law permitting. Only 24 states allow municipalities to file for bankruptcy, and states themselves cannot seek bankruptcy protection.

Municipal bankruptcies are rare, even during a period of extreme fiscal stress such as the aftermath of the financial crisis. Since 2010, only eight local governments have successfully filed for Chapter 9 bankruptcy, according to the National Conference of State Legislatures (NCSL). (Five other cases were dismissed.) An additional 29 public entities, such as utilities and authorities have filed in that time period, according to the NCSL.

Creditors have less leverage in municipal bankruptcies than in corporate or individual bankruptcy proceedings. That’s because it’s more difficult to force the debtor (the municipality) to divert revenue to pay the creditor. Public entities, after all, must continue serving the public.

[B]What Can Investors Do?[/B]

If you find yourself exposed to a troubled municipality, you can ask your broker or investment adviser to keep you updated on relevant developments in bankruptcy court to help determine how best to proceed.

But the best time to protect against risk is at the time of purchase.

Investors should understand the revenue streams on which their municipal bonds depend. Are the bonds backed by a local government’s general revenues, meaning that officials can raise taxes if there isn’t enough cash to repay bondholders? Or are the bonds backed solely by an expected income stream from, say, a public utility? Are the bonds insured? Investors should also have an idea of the issuer’s fiscal health, credit quality and financial position.

Remember that high-yield municipal bond funds and high-yielding individual bonds usually pay higher interest rates because they’re asking investors to take bigger risks, so it is always a good idea to have a clear understanding of what those risks are before investing.[/QUOTE]