Municipal Bankruptcies Continue To Draw Headlines

What does it mean for investors when a city, country or territory declares bankruptcy? When placed in the context of the thousands of government entities in the U.S., it is an infrequent occurrence. However when it does happen, it certainly grabs our attention. It is a reminder that municipal bonds, like all bonds, carry some risk.

Hundreds of bankruptcies by municipalities have been recorded since the 1930s. The largest ever-municipal bankruptcy occurred in 2013, when the city of Detroit filed for Chapter 9 protection from creditors. The troubled city, with a declining tax base, was unable to meet all of its financial obligations and required a restructuring of its debt(1). Other cities such as Chicago and Atlantic City, New Jersey and the territory of Puerto Rico are facing financial challenges that have put them in recent headlines.

In the case of Detroit’s bankruptcy, the city’s declining economic fortunes resulted in a notable drop in its tax collections. Other governments have run into problems due to overwhelming pension obligations, financial mismanagement or various other problems that created a budget crisis.

A reality check about debt issuers

Individuals often choose to invest in bonds in order to generate a stream of income on a regular basis. In essence, investors are lending money to the bond issuer, who promises to pay back the principal, but in the meantime, makes interest payments to the investor. Municipal bonds are particularly attractive to some investors because income is generally free of federal income tax, and sometimes state and local income tax as well.

Any bond carries risk. One of the most important that investors must consider is the possibility that the issuer will default on debt securities that were sold to investors. Generally, investors tend to think that there is little likelihood that a government entity that issues a bond will default on its obligation. After all, a municipality or other government unit can issue bonds that are backed by its authority to levy taxes on citizens. But this does not preclude the potential for the municipality to run into a financial shortfall.

The fact that municipal bankruptcies occur for a variety of reasons and through different economic climates indicates that taxing power alone will not fully protect investors. Bankruptcy courts will often require these government entities to take steps to improve their financial standing, including selling assets as a way to raise money to help pay creditors.

Municipal bonds may work for the right investor

Most investors view bonds as an asset class that potentially carries less risk than some other types of assets such as stocks or commodities. Bonds also tend to perform differently in various market environments than asset classes like stocks. Therefore, bonds can play an important role in diversifying a portfolio. That type of diversification can be a valuable benefit for investors, and municipal bonds can play a role.

While a municipality may run into financial difficulty, its bonds can remain attractive. Some investors view the unique ability of these bonds to provide income that is generally free from federal income tax (and sometimes from state and local income tax) worth the risk. As you consider your options in the bond market, work with a financial professional who can help you determine what investments make sense in the context of your portfolio and financial goals.

(1) – “Restructuring Municipalities…What Creditors Need to Know About Chapter 9 Bankruptcies,” ABFJurnal.com (http://www.abfjournal.com/articles/restructuring-municipalities-what-cre... ); “Detroit bankruptcy teaches muni bond investors painful lesson,” Crain’s Detroit Business, Nov. 7, 2014;

(2) – “Recalling New York at the Brink of Bankruptcy,” New York Times, Dec. 5, 2002.

Rob Davis lives in University Place with his wife Lorri and their youngest son, Parker. He is a Financial Advisor and CERTIFIED FINANCIAL PLANNER practitioner™ with Ameriprise Financial Services, Inc. in Tacoma, Washington. Rob specializes in fee-based financial planning and asset management strategies and has been in practice for 38 years. He is licensed/registered to do business with U.S. residents only in the states of Washington, Idaho, Arizona and California. You may contact Rob at ameripriseadvisors.com/robert.g.davis.

Investment advisory products and services are made available through Ameriprise Financial Services, Inc., a registered investment adviser.

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.

Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains.

Ameriprise Financial and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.

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