Harrisburg, Pennsylvania’s financial woes have attracted the attention of municipal bond investors. Harrisburg’s city council recently tried to file for Chapter 9 bankruptcy. The courts are now trying to decide whether the city can file for bankruptcy and what this might mean for bond holders. Meanwhile, the State of Pennsylvania has threatened to take over the city’s finances adding yet another dynamic to the situation. How Harrisburg’s situation gets resolved could have far-reaching implications for bond holders of other municipalities facing severe financial problems.
The municipal bond market has been on edge since Meredith Whitney predicted massive bond defaults last December. The municipal bond market dropped at the beginning of the year but recovered nicely and has had a good year so far.
Despite Whitney’s dire forecast, most state and local municipalities should be able to meet their debt obligations. Bond interest payments average 2.7% of total spending for the 50 states and 4% for local governments. Those percentages could easily be covered by tax increases or spending cuts and most likely will be some combination of the two.
Diversification is the key to building a municipal bond portfolio. Spread your holdings over general obligation (bonds backed by taxes) and revenue bonds. Follow rating changes on a regular basis. The rating agencies have been severely criticized for dropping the ball during the financial crisis. Today the agencies are more likely to issue a credit downgrade, as the recent downgrade of U.S. Government obligations has demonstrated. Your bond portfolio should also diversify between different regions and types of municipalities. Consider buying a municipal bond fund if you are uncomfortable investing in individual bonds. Be sure to pay attention to the duration of any fund you are considering. Interest rates are at historical lows and will eventually need to move higher. A fund with a long duration may lose value when interest rates start to rise.