Fresh Water and Other City Services Can Yield Refreshing Returns for Bond Investors
By Chad Rach
Capital Group Fixed-Income Analyst
Many things have gone right for municipal bonds over the past few years, as evidenced by their consistently strong returns. Still, the well-reported financial difficulties of Detroit, Chicago and Puerto Rico are a reminder of the potential downside for some securities when municipalities run into trouble. As a fixed-income analyst, I thoroughly evaluate the risks and rewards of muni bonds, and strive to identify those with both compelling yields and solid credit quality that may have been overlooked by the market. This philosophy is shown in my approach to highly rated municipal bonds.
Broadly speaking, there are two types of municipal debt: revenue and general-obligation. As the name implies, revenue bonds are backed by dedicated cash flows, typically the fees that consumers pay for water, sewer or other public services. By contrast, general-obligation bonds are backed by good-faith promises to raise sufficient revenue — typically from real estate or other taxes. GO bonds, as they’re known, often finance projects such as parks and other basic government infrastructure, which have a clear public benefit but don’t as a rule generate sufficient cash flow on their own to meet their debt obligations.
It’s important to point out that a variety of other tax-exempt securities are labeled as revenue bonds. But many of these are backed by narrow governmental revenue streams or cash flows from private businesses that have congressional authorization to borrow on a tax-free basis. These include hospitals, senior-living centers, higher-education organizations and other corporate entities. These securities frequently offer excellent value in tax-exempt portfolios, but for the purpose of simplicity, I’m referring only to mainstream revenue and GO bonds in this article.
Historically, the vast majority of revenue and GO bonds have been considered by the rating agencies to be extremely high quality, and I expect that paradigm to continue. In fact, depending on market conditions and other factors, I may recommend both types of securities for client accounts. But in general, I tend to favor revenue bonds because I believe they offer an appealing combination of safety and yield.
It’s essential to analyze the creditworthiness of munis.
Given the complexity of the fixed-income market and the sheer number of individual bonds, the ability and resources to conduct thorough research are essential. Before taking any action, my colleagues and I perform extensive analysis to gauge an issuer’s financial underpinning and long-term creditworthiness. In some cases, that can include an assessment of specific industries and sectors, as well as the underlying projects that the bonds are financing. For example, if a city is seeking to refurbish its wastewater treatment system, we might analyze whether the existing tax base is strong enough to handle the new debt and whether the operator has leeway to adjust the rates of industrial or residential customers, if necessary.
One of the compelling features of revenue bonds is their valuation. I frequently find them to be more attractively priced than comparable GOs, meaning it’s possible to obtain slightly higher yields on these securities without sacrificing credit quality. The yield differential between revenue and GO bonds is due largely to the methodology that credit rating agencies use to analyze each of them. In my opinion, the rating agencies tend to slightly underestimate the credit quality of revenue bonds. That has led to the market demanding higher yields compared to for GO bonds, providing opportunities to acquire securities at favorable valuations.
Revenue bonds are preferable to GOs during a municipal bankruptcy.
Revenue bonds typically have another advantage. When municipal issuers have encountered significant financial troubles and resorted to debt negotiations — either privately or under Chapter 9 bankruptcy proceedings — principal and interest payments have been more reliable on revenue bonds than on GOs. Although defaults or restructurings on all types of muni bonds are rare, this is nonetheless an important consideration for investors.
Oddly enough, until a few years ago it was widely believed that GOs were safer than revenue bonds. The prevailing market assumption was that a state, city or county had greater financial wherewithal to make good on its GO debts than did a smaller project financed by revenue bonds. In other words, a water district was considered likelier to declare bankruptcy and default on its debt than the city in which it was based. It was assumed that cities or states could simply raise taxes to compensate for any funding shortfalls, and that they would willingly do so to avoid any damage to their credit ratings. That logic was rarely tested because governments faced negligible economic stress. The relatively few governments that encountered severe budgetary strains were often small or covered by bond insurance, which limited investor scrutiny.
The perception of GOs changed in the past several years after some issuers faced unusual financial stress. The most prominent case involved Detroit, which said it couldn’t make good on all of its obligations and filed for bankruptcy protection. The city eventually paid GO bondholders only a portion of the amounts they were owed. The travails of Detroit and a handful of other cities demonstrated that municipalities sometimes either can’t — or are unwilling to — raise taxes to satisfy debt holders. Some cities and states have special protections for GO bonds. But that varies among jurisdictions, and many others have strict limits on the degree to which local governments can raise taxes. Even for municipalities that can boost taxes, it’s often impractical or politically infeasible during trying economic times.
However, even while Detroit and some others backed away from their GO debt, they continued to honor their revenue bonds, notably those backed by water and sewer enterprises. They did so partly because federal bankruptcy laws provide stronger protections for revenue bonds than for GOs. The U.S. bankruptcy code has special provisions for revenue bonds that mandate payments to be made on them while an issuer is in bankruptcy.
As I mentioned earlier, defaults on muni bonds are rare and many GOs have excellent credit profiles. In today’s environment, however, we are excited about building high-quality portfolios around revenue bonds to take advantage of attractive yield premiums and potential for superior downside protection. In all cases, our fixed-income team thoroughly analyzes the merits of each security in an effort to seek compelling yields that are accompanied by reliable credit quality.
Chad Rach is a fixed-income analyst who covers tax-exempt bonds. Based in Los Angeles, he has 23 years of investment experience and has been with Capital Group since 2004.