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August 20, 2012

The municipal bond market continues to have among the lowest default rates of any debt instrument. However, much has been in the news recently regarding the few cities that have recently filed for municipal bankruptcy. Some investors may own bonds issued by a City in bankruptcy, but could continue to receive principal and interest payments as scheduled. Likewise, some investors may own bonds issued by an otherwise reasonably healthy City, but the bond could be in a form of default. By understanding the underlying credit and security of a given bond, an investor can better understand their expected principal and interest payments.

Debt at the local level is generally secured by a specific revenue source, or is appropriated in the City’s general fund on a parity basis with other creditors. Specific revenue sources can include net revenues of a given enterprise, property taxes, sales taxes, or other restricted lines of revenue. General obligation bonds are voter approved, pre-petitioned debt, secured by (un)limited ad valorem property taxes. Enterprise level debt is generally secured by net revenues of the underlying enterprise. Debt issued to finance public improvements for special districts are secured by taxes levied on taxable property in the given district. Redevelopment agency debt is secured by tax increment revenues allocated to the successor agency from a given project area. So long as the restricted lines of revenue securing a given bond continue to be sufficient to cover debt service when due, that individual bond is scheduled to continue to receive principal and interest payments when due, regardless of the status of the issuing city or county, as long as such revenues are kept separate and distinct.

Other lines of debt may be secured by a given city’s general fund, and could be referred to as a certificate of participation, a lease revenue, or a pension obligation bond. Some investors have relied heavily on underlying issuer credit ratings to evaluate many of these types of debt. For example, prior to the July 10, 2012 meeting of the San Bernardino City Council, when the City voted to pursue Chapter 9 Bankruptcy, Standard & Poor’s had assigned a ‘BBB+’ rating with a stable outlook to the City’s lease revenue bonds, two notches above the lowest investment grade credit rating. They cited the general credit-worthiness of the City, and the covenant to appropriate base (lease) rental payments. This, despite the fact that the City had faced severe budget deficits, and had significantly depleted its reserves over the past few years. Being reactive in nature, Standard & Poor’s proceeded to downgrade the same bonds to ‘C’ in the period following the meeting.

It had been previously perceived by credit ratings agencies that cash flows and balance sheets mattered less, and that willingness and ability to pay mattered more. While most appropriation backed debt for financially sound cities should continue to pay when due, there is reason to better understand the underlying financials of appropriation backed debt, particularly changes in net assets and cash flows. While debt is rather manageable across many cities, pension and healthcare related expenses for current and former employees is increasing at a faster rate than most forms of tax revenue, which is stressing the financials of many municipalities. Some have sought to combat these expenses with layoffs and furloughs, but the expenses continue to increase, which has brought into question some issuers willingness to pay. By understanding the underlying fundamentals of a given bond, an investor can help give themselves better peace of mind.


This report is prepared for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument or service. Market prices and other data may be obtained from outside sources and is not warranted as to completeness or accuracy. Any comments, statements and/or recommendations made herein are subject to change without notice, and may not necessarily reflect those of Alamo Capital. Past performance does not guarantee future results. Alamo Capital has no affiliation with any political party. Investing involves risk. Consult with a Financial Professional for additional information to determine the suitability of this or any other financial product or issue as it relates to your particular situation.

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