In an effort to address increasing concerns in the municipal market, James Dearborn, managing director of municipal bonds at investment firm Columbia Management, has been touring the country and speaking with investors.
“I try to emphasize that what we’re seeing is probably the most difficult period since the Great Depression, but the way we [Columbia Management] see it, it’s not going to manifest itself in widespread defaults,” said Dearborn. “There will certainly be credit deterioration, which will be reflected in lower rates, but we don’t believe in the likelihood that people will see large losses in their principal of the money they’ve invested in municipal bonds.”
As he travels around the country, Dearborn said the most common question from investors is: How are state and local governments going to make it through this period?
“The answer is the way they’ve always done it; they’re going to make the difficult decisions. They’re going to have to make cuts in services that will be real and meaningful,” he said.
Dearborn said much of the fear in today’s municipal bond market comes from an inexperienced few who have decided to make outlandish comments about what’s going to happen next.
“The problem is people who make predictions about widespread defaults are doing it on a macro basis,” he said. “The way we see it is on the individual municipality level.
“We’re looking at credits every day in our portfolios,” added Dearborn. “While we’re seeing stress, we’re not seeing signs that people aren’t going to make their debt service payments on a timely basis. There will be the odd few that will default but we expect that will be the exception and not the rule.”
Even as the exception, however, Miller Nash LLP Attorney Dustin Klinger said the effect of a small number of defaults could be damaging.
“Austerity measures make it [investing in municipal bonds] more attractive as an investee, but I think if we had a couple municipal bankruptcies that would probably scare people again,” said Klinger, who works out of his firm’s Vancouver office and specializes in real estate, business transactions and finance.
At this point, Dearborn said he’s just not seeing municipalities being forced to the brink.
“At that [individual] level we see cities, towns, school districts, states and all varieties of government dealing with these problems in a responsible way. It’s not easy for them, but we’re seeing the tough decisions being made to balance their budget,” said Dearborn.
A local case
Earlier this month, Dearborn’s speaking tour included a stop at Vancouver’s Heathman Lodge – an event presented by U.S. Trust.
Because of its proximity to Oregon, Dearborn said municipals in Southwest Washington present an intriguing case.
“It’s interesting here in Vancouver, being on the border between Washington state and Oregon – two states that have taken very different paths,” said Dearborn. “One (Oregon) has gone toward higher marginal tax rates to generate income to offset some of the cuts [in services]. In Washington, obviously the proposal to impose a new rate on the highest income earners was rejected, so it’s going to be more about spending than it is about revenue.”
Despite their different paths, Dearborn said Washington and Oregon are acting responsibly.
“We see them as high quality credits that have largely taken correct measures to try and achieve balance,” he said. “Republicans and Democrats
are realizing that you have to arrive at balance at the end of the day. And when we’re looking at credit value, we’re looking for balance.”
Inflation & unemployment
The mystery eight-ball when it comes to today’s fixed income securities, according to Klinger, is interest rates and the role of inflation.
“I do think there is some shying away from long term bonds right now because investors think at some point the federal deficit is going to create inflation,” said Klinger. “And if you buy a five percent 30-year bond today and three years from now bonds are spitting off eight or 10 percent, you’ve got a lemon.
“If you’re the one holding the low paying bond, inflation just leaves you in the dust,” he added.
If inflation does begin to pick up and interest rates rise as a result, Dearborn expects the Federal Reserve to raise the federal funds rate.
“They’ll raise the funds rate and do other things to try and limit the inflationary pressures in the economy,” said Dearborn. “However, when you look at the unemployment rate there’s reason to believe inflation isn’t going to take off because there’s enough slack in the economy. Those two factors [inflation & unemployment] are certainly considerations for any fixed income manager.”