The surge in municipal bankruptcies across the country, including three in California since January, has been unsettling for bond market participants. Moody's Investors Service, a national rating agency, recently announced plans to conduct in-depth reviews of numerous California cities, especially those cities that have declared fiscal crises. The Federal Reserve Bank of New York suggested this month that "municipal defaults are far more common than frequently cited statistics suggest."
Despite the anxious commentary and intensified scrutiny, it remains unclear whether the increase in municipal bankruptcies has had any material detrimental effect on the issuance or purchase of municipal obligations to date, or if it will in the future. If municipal bankruptcy filings continue to increase, however, the market for municipal debt, particularly obligations secured by an issuer's general fund, may suffer.
When a city files for bankruptcy under Chapter 9 of the United States Bankruptcy Code, it is permitted to restructure and discount its debt, including obligations secured by the city's general fund. Consequently, in a bankruptcy scenario, investors owning these obligations risk being repaid less than the full value of their investment. In addition, should rating agencies like Moody's continue to downgrade municipal credit ratings, the cost of borrowing will increase, adding more strain to the bond market.
Despite the tumultuous economic environment, bond yields remain historically low and municipal bonds remain an attractive vehicle for investors seeking tax-exempt returns. If the country continues its economic recovery and municipalities continue to tighten their fiscal belts, the recent flurry of municipal bankruptcies may ultimately prove inconsequential to the overall municipal market.
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