Over the past month, I’ve been getting a lot of questions from clients around specific credit events in the municipal bond market.  Recent credit downgrades and bankruptcies clearly have some muni investors on edge.

The past few months certainly have been a bit of a roller coaster ride for the municipal market.  In December I wrote about the fear of a potential loss of the tax-exempt status of municipal bonds, which drove a sell-off in the muni market.  After the Fiscal Cliff was resolved and it was clear munis would remain exempt from federal taxes, investors flocked back to the sector and bond prices rose. Then in March we saw another pullback, potentially driven by high net worth investors selling their munis and using the proceeds to pay 2012 tax bills.

On top of all of this has come news about the credit worthiness of specific municipal issuers. Below are some of the most talked about names and what recent developments may mean for muni investors:

Stockton, California.  After filing for bankruptcy protection in June 2012, the city received court approval to go ahead with Chapter 9 bankruptcy proceedings.  Stockton was one of three California cities to seek bankruptcy protection last year, including Mammoth Lakes and San Bernardino.  The combination of falling real estate values and too much public sector spending, including pension obligations, took a toll on the cities’ finances. Today the impact of these events is already priced into their outstanding bonds.

Puerto Rico. Traditionally investors have added Puerto Rican bonds to both national and state-specific portfolios because they are exempt from US federal and state income taxes (83% of single state mutual funds have exposure to Puerto Rico). Currently the Commonwealth of Puerto Rico faces underfunded public employee pension obligations and a slowing economy, but the administration is reviewing steps to reform the pension system and tax policy.  Puerto Rico was downgraded to Baa3 by Moody’s in December and BBB- by Fitch and S&P in March. This puts Puerto Rico at the lower end of the investment grade credit scale.  Yields on Puerto Rico’s bonds increased in response to the downgrade.  If Puerto Rico falls below investment grade and into high yield territory we could see bond prices decline as some investors sell their positions.

State of Illinois. The state of Illinois was recently downgraded to A- from A by S&P as pension obligations for public employees weighed on the state’s finances. The state legislature is currently considering proposals to deal with the shortfall. Illinois is still able to issue debt and experienced high levels of demand for recent bond offerings.

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