historical levels. Despite the significant
outperformance of the longer-term
portion of the market in 2012, the
municipal yield curve stood at about
278 basis points (bps) as of January
21, 2013. This was still steeper than the
long-term average and may appear
even steeper when considering that
it was less than 50 bps in early 2007,
which was before the Fed started its
aggressive policy accommodation. The
portion of the curve consisting of 10-
to 30-year maturities is even steeper
compared with historical averages.
Similarly, the extreme market dislocation
of 2008 left credit spreads extraordinarily
wide. Even after tightening last year,
the yield spread of high-yield muni
bonds over investment-grade munis
was 341 bps as of January 31, 2013, 55
bps wider than the long-term average.
These relative value measures may
appear even more attractive when
considering that the tax-equivalent
yields on municipal securities are
well above the yields on corporate
bonds of similar credit quality. For
upper-income investors, this may be
of particular importance following the
reversion of the top income tax bracket
to 39. 6 percent and implementation
of the 3. 8 percent Medicare surtax.
Relatively high yields can indicate the
presence of additional credit risk. But
that relationship may not hold when it
comes to the tax-equivalent yields on
municipal bonds, especially considering
that defaults of municipal bonds with
investment-grade credit ratings have
been exceedingly rare. For example,
the average cumulative default rate for
investment-grade municipal bonds
was 0.08 percent from 1970-2011,
compared with a rate of 2.61 percent
for investment-grade corporate bonds
over the same time period, according
to Moody’s Investors Service.
Although municipalities have a long-term track record of stability, the
current economic environment has
affected many municipal budgets.
To preserve their credit quality,
most cities and states have taken
significant steps involving increased
revenues, reduced expenditures,
and adjusted retirement plans.
State revenues generally depend on
income, sales, and/or corporate taxes.
Therefore, when these measures
declined during the prior recession,
state revenues fell sharply as well. Yet,
as the economy recovered and states
implemented additional ways to raise
revenue, state tax receipts rebounded
with 11 consecutive quarters of increases
that culminated with a 2. 7 percent
increase in the third quarter of 2012.
Revenues at the local level are more
dependent on property taxes, which
generally lag the movement in the
broader economy. But these are also
improving. After an increase of 6. 2
percent in the second quarter of 2012,
third-quarter property tax revenue
increased 8 percent from a year earlier.
pensions could be unsettling if
they continued to delay addressing
the situation. However, between
January 2008 through June 2011,
35 states implemented a variety of
measures to reduce benefits in state-sponsored pension plans, mostly to
future employees. In addition to the
effect that these changes can have
on improving plans’ funding levels,
when interest rates eventually rise and
the economy strengthens, the funds’
investment returns should improve
and increase their funding levels.
Finally, discussions about quantifying
pension shortfalls usually incorporate
health care costs. However, health care
benefits are generally not legally binding,
which means that municipalities
can make changes that affect current
Municipal bankruptcies should
remain exceedingly rare, but it is
possible that other highly distressed
cities might pursue Chapter 9 as
a way to reorganize, even though
the number of filings decreased
in 2012 compared to 2011.
Meanwhile, municipalities have
continued to make difficult decisions
in terms of curtailed expenditures.
Since December 2007, employment
at the state and local levels declined
by 489,000 through December 2012.
Although these job reductions do not
support broader economic growth,
they do reflect municipalities’ ability
to reduce expenditures to close
deficits in their operating budgets.
employees. In addition, health care
benefits are not necessarily lifelong
commitments, as retirees may use
health care benefits as more of a bridge
from the time they retire to when
they may be eligible for Medicare.
Therefore, some of the potential
medical costs that are included in many
calculations of future liabilities might
not actually be paid in the future.
The acknowledgment that municipalities
have many years to deal with their
3 The Specter of Chapter 9
Despite the flexibility of most cities
and states, the fiscal issues in certain
municipalities have developed into
current, acute situations. Indeed,
bankruptcy filings of a few cities have
received widespread media attention,
even though many of these cities and
towns have relatively little outstanding
debt. And the financial distress faced by
these municipalities often can be traced
to specific events, idiosyncratic structural
issues, or a combination of both.
One public finance topic that continues
to generate headlines is the widespread
underfunding of retiree pension
and health care plans—a gap that
reportedly reached $1.38 trillion in 2010,
according to a June 2012 report from
the Pew Center on the States. While the
underfunding figures are presented
as a widespread problem, most states
have adequate funding levels, and those
states with underfunded plans still have
many years to deal with these deficits.