In the past month, the California cities of Mammoth Lakes, Stockton and San Bernardino have all declared bankruptcy. Though the full effects of these bankruptcies will not be known for quite some time, investors should be aware of their possible ramifications.
The most recent bankruptcies may prompt many cities into rethinking their employee retirement offerings. Some may follow San Jose and San Diego in increasing the amount public workers have to contribute towards their pensions. Others may look at transforming their pension plans into public/private hybrids.
Some cities may transfer some of their public workers onto 401(k) plans, and keep other workers on traditional pension plans. Historically, when cities have followed this model, they have kept police officers and public safety professionals on traditional pension plans, but transferred other public employees over to 401(k)-type plans.
Rarely do cities eliminate public pension plans altogether. Some municipalities have sought to transition their pensions over time, keeping longtime employees on old fashion pension plans, while adding new employees to 401(k) plans. Regardless, the traditional public pension plan is likely going to see some changes.
Increased usage of the private sector may be key to many cities’ recovery plans. Whether public employees like it or not, cities are likely going to move a great deal of their services out of public employee hands and into private sector hands. Traditional public services like trash collection, park management and animal control may be turned over to for-profit or non-profit companies. As the for-profit companies gain steady streams of income from these cities, investors are likely going to be more curious about them.
At first, investors may get nervous when cities start to restructure their communal and retirement services. They may wonder how close these cities are to bankruptcy. Specifically, investors are likely going to worry about the fate of their municipal bonds. Many municipalities have come under significant stress because of the recent global financial crisis. However, only a small handful of municipal bond issuers have been unable or unwilling to honor their debt obligations. Indeed, there are relatively few instances in history when cities have not paid back municipal bonds.
When cities do start to restructure their pension programs or their city services, it usually means that their economies have been adversely impacted for quite some time. Investors should not be shocked or unprepared when cities start to restructure their services.
Even if some municipalities become unable to pay back bonds, investors should not necessarily shy away from investing in the municipal bond market generally. There are thousands of municipalities that issue bonds, each with their own unique capacity to generate revenue for interest and principal payments. The once important role of municipal bond insurance has been substantially diminished. Therefore, careful scrutiny of the underlying credit quality of each bond issuer has taken on new significance for investors and should be the cornerstone of municipal bond investment.
Interest in municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, local tax-exemption typically applies if securities are issued within one’s city of residence.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk.
Mike Moxley is a Vice President Wealth Advisor with Morgan Stanley Smith Barney in San Francisco, CA. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. Past performance is no guarantee of future results. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates.