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Thread: State and Local Bonds- CAUTION !

  1. #1
    Banned Eric Stoner's Avatar
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    Default State and Local Bonds- CAUTION !

    Given the precarious condition of many states and cities, it's worth considering just how safe some of these bonds really are.

    1. The same credit rating rating agencies that gave AAA ratings to various mortgage backed securities also rate these state and local bonds.

    2. Bonds come in two types- revenue and general obligation. Revenue bonds are backed by a specific revenue source. Usually issued by a public authority, they are repaid by bridge and tunnel tolls, airport fees or transit fares. Some are backed by room and board at universtities- Dormitory Bonds or hospital bills being paid- Hospital Bonds.

    General Obligation Bonds are backed by a PROMISE to repay from a state or city.
    And they are, so long as those entities have the money. California has just barely avoided default and N.Y. is headed directly for one of its own. In 1975, N.Y.C. defaulted on GOL bonds it issued. Carter stepped in and signed Federal loan guarantees so N.Y.C. and N.Y.S. could restructure their debt. Who says the Feds are going to do it again ?

    3. It used to be that bondholders were first on line in any bankruptcy. Even a municipal bankruptcy. Two things to remember- what happened to the holders of Washington Public Power Supply System bonds in the 80's when "WHOOPPS" went bankrupt and defaulted ? That was a government authority. Did the state of Washinton step in and pay off the bonds ? Eventually they did, but a lot of folks depending on their monthly coupon clipping to supplement their Social Security had to wait to get paid and they could never sell those bonds. Today, 15% of every Washington resident's electric bill goes to pay off those bonds. How long would you want to wait until Bloomberg could auction off Gracie Mansion and re-zone Central and Prospect Park for condos and scattered site McMansions ?

    Secondly when GM and Chrysler went bankrupt, the bondholders were moved from the front of the line of creditors to the back. That won't happen with a municipal bankruptcy or state financial crisis, why ?

    4. Most of these bonds are triple tax free. But they are subject to capital gains taxes if you sell them at a gain. Not very likely if we get inflation but if there is another wave of defaults and another financial crisis, who knows ?

    For the foregoing reasons, I'd rather be holding revenue as opposed to GOL type bonds. For a LOT of reasons, I'd prefer Brazilian Olympic Games Bonds or Shanghai Transit Authority.
    Last edited by Eric Stoner; 11-11-2009 at 11:59 AM.

  2. #2
    Banned Melonie's Avatar
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    Default Re: State and Local Bonds- CAUTION !

    In keeping with recent commentary on the relevance of Dollar Den posts for dancers, allow me to elaborate on the topic of Municipal Bonds. Unlike corporate bonds or bank CD's, Municipal Bonds pay regular interest which is typically EXEMPT from US federal, state and local income tax. Thus they are a 'favorite' investment for high earning high tax bracket residents of high tax rate states ... including full time dancers in New York and California for instance, as well as their upscale club customers !

    A bit of basics is probably in order in regard to the differences between bonds and CD's. With a CD, if you purchase a $10,000 5 year CD for instance, you are guaranteed to receive perhaps 3.35% annual interest for each of the next 5 years. This interest is fully taxable. Additionally you are guaranteed to receive your initial $10,000 back at any time you choose to 'sell' the CD prior to maturity ( although you may be hit with an 'early withdrawl' penalty for doing so). And even if the bank that issued the CD goes bankrupt, you are still guaranteed that your $10,000 will be paid back at maturity via FDIC insurance.

    But with bonds of any kind, the underlying 'cash price' of the bond does not remain constant except at initial issue and at maturity. Thus the purchase of a newly issued $10,000 face value 5 year New York bond would cost your $10,000, and you are 'guaranteed' to get $ 10,000 back if you hold the bond to maturity (assuming that New York is still solvent and able to pay). But if you choose to sell the bond in the meantime, the cash price you will receive can vary. This is the result of the 'fixed' interest rate of your bond presenting higher or lower 'value' than the new interest rate paid on newly issued 5 year bonds a year or two or three down the road. Bond price variations, however, are usually limited to 10% of the face value, and typically more like 5%. But if your intent is to hold the bond to its maturity while collecting interest payments, then bond price variations really don't matter (again assuming that the bond issuer is still solvent and able to pay).

    However, as Eric points out, the level of state budget deficits in states like New York and California are now starting to send a wave of fear through the investment community ... fear that these states may be forced to send out IOU's instead of bond interest payments in cash. If this were to happen, then the initial cash that the bond purchaser 'loaned' to New York or California would be 'trapped' until the bond matures ... with further fear that these states may also be forced to pay off their maturing bonds with IOU's instead of cash as well ! This may be enough of a financial force to prompt current bond holders ( owners ) to sell off their bonds at a deeply discounted price versus face value in order to 'liberate' some portion of their otherwise 'trapped' initial investment money.

    From a long term investor's standpoint, the ability to buy up a two year old 5 year municipal bond, for example, at a 10% discount price versus face value, which also pays 2% interest that is free from federal, state and local income taxes, may seem tempting. Of course this also involves the would-be investor's assumption of the risk that three years down the road these states will NOT be able to pay off the bond's face value in cash when it matures ... i.e. they may be stuck holding state IOU's or may be stuck in state bankruptcy proceedings ( where bondholders have not been treated very well in the recent past ).

    However, if you are of the opinion that California and New York will be 'bailed out' of their budget problems in the future ( as they were this year via the federal stimulus package ), then the possible purchase of a California or New York Muni bond at a deep discount to face value may represent an extraordinary opportunity both for tax free interest earnings ( = 2.2% assuming a $9,000 purchase price for a $10,000 face value 2% bond) as well as for capital gains at maturity ( = $1000 as the result of a $9,000 purchase price versus $10,000 cash payment at maturity).

    But the flip side is that your $9,000 initial investment may wind up being 'stranded' for many years to come, may be 'crammed down' to a lower amount via a future bankruptcy court ruling, etc. as the result of ongoing state budget problems or potential state bankruptcy.

    As always, caveat emptor

    ~
    Last edited by Melonie; 11-11-2009 at 11:35 AM.

  3. #3
    Banned Eric Stoner's Avatar
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    Default Re: State and Local Bonds- CAUTION !

    Thank you Melonie for getting down to more of the financial nitty gritty.

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