Municipal Issues and Your Wallet

Greece has been front and center in the news over the last several years.

That country entered the Eurozone without fully disclosing its debt (otherwise they may have been barred from entry) and now Greece and the rest of Europe are paying the price.

One issue exacerbating Greece’s debt problem is the fact that they can’t devalue their currency.

This can often help a country that is struggling with a high debt load because it lessens the value of the currency and thus lessens the debt that is denominated in that currency. The debt is easier to pay off because it is worth less.

This pathway is not open to Greece as a member of the Eurozone because the Euro is propped up by its stronger member countries.

In a similar scenario much closer to home, Puerto Rico, a United States Territory, issues debt in U.S. dollars. Because of the continuing strength of U.S. currency, (given our strong economy in comparison to other countries around the world) Puerto Rico’s debt is worth more.

Puerto Rico currently has $72 billion in debt outstanding. That is a huge number for a population of 3.62 million (in contrast to Pennsylvania’s population of 12.79 million). At the end of June, the governor of Puerto Rico announced that the $72 billion in debt was “unpayable.” This was not an unexpected announcement. The commonwealth has been in trouble for years from government overspending, high energy costs and huge debt issuance.

How might all of this this affect you? Many high income earners own municipal bond funds and over 30 percent of muni bond funds have holdings in Puerto Rico, more than half of which are insured. Funds also typically limit their exposure in any one area to under 5 percent, especially given the known issues in Puerto Rico. Be sure to check any funds or bonds you may own for exposure.

There are two possible avenues toward a resolution in Puerto Rico. One is to permit Puerto Rico to declare bankruptcy, which is currently not allowable by U.S. commonwealths under the law, or bail them out, which is unappetizing to American taxpayers. The fact remains that something will need to be done because Puerto Rico can’t pay its debts.

When countries, municipalities or cities declare bankruptcy, it makes borrowing more difficult. Entities that can issue municipal bond debt are lucky as they can issue their debt at a lower interest rate. Why? Because municipal bonds are given special tax treatment under the law.

All bonds are a loan to the issuer at a specific interest rate and duration. The interest rates on municipal bonds are generally exempt from federal taxation, which means citizens in higher tax brackets typically get a much better deal buying municipal bonds than other types of bonds (capital gain taxes can still apply when selling).

The term that exemplifies this is ‘tax equivalent yield.’ Calculations using a person’s Federal marginal tax bracket can determine if a tax-free bond or a taxable bond are more advantageous. Of course, if your tax bracket is high, municipal bonds look better in most instances.

This advantage was created so that municipalities (schools, cities, water and sewer authorities, etc.) would have an extra benefit to offer investors and municipals would have lower borrowing costs (lower interest on their bonds means less expense when paying their interest).

Two general types of municipal bonds exist (as always there are complications but we will stick with the basics): General Obligation Bonds (GO) and Revenue Bonds. General Obligation Bonds or GOs are backed by the issuer’s taxing power. Revenue Bonds are funded by a specific project (think a toll road or power plant). GO bonds are considered slightly more secure than revenue bonds.

Municipal bonds are considered fairly safe and rank after Treasuries when looking at bonds overall. They still have risks associated with them similar to other bonds (interest rate risk, default risk, etc.). In this article, I am focusing on default risk. I’ve mentioned Puerto Rico, but Detroit is a prime example of succumbing to default risk.

Why is this important for someone in State College to know? Because Pennsylvania is on the list of states in a pension crisis. Two pensions are sponsored at the state level, The State Employees Retirement System (SERS), which is funded by employee contributions, state contributions and investment returns, and the Public School Employees’ Retirement System (PSERS), which is funded by employee contributions, district contributions and investment returns.

These two entities are estimated to have unfunded liabilities of $65 billion by 2021 unless things change. This is similar to what public companies began to understand with their defined benefit or pension plans. It is difficult to fund, invest and calculate what’s needed year to year to provide future benefits, especially with people living so much longer.

This is why most employers are moving toward a defined contribution or, as most people call them, 401ks (although they come under many different names). The numbers and issues raised were compiled by Pennsylvania’s Institute of Certified Public Accountants and state officials estimate that each taxpayer in Pennsylvania would have to contribute $13,000 to wipe out the debt.

In short, changes need to be made. If Pennsylvania were unable to pay its liabilities, it would be like any other entity: bankruptcy or non-payments of debt would ensue and municipal bonds based on Pennsylvania’s ability to pay would be at risk. There are many ways to bring down the pension debt but almost all face a hurdle.

Pension benefits can be cut, new workers can be placed in a defined contribution plan, pension bonds could be issued (‘kicking the can down the road’) or taxes could be used to pay the unfunded obligations. The mounting debt has caused downgrades to our debt rating and thus caused higher borrowing costs for our state.

If we continue to ignore the issue, we face the same decisions Puerto Rico and Greece now must consider. Pennsylvania can’t afford that chance and changes need to be made now.