Yes, a city can go bankrupt. Detroit makes this reality clear to investors, especially municipal bondholders who are learning what the “full faith and credit” of the ghost town is worth – not much!
Whether Detroit makes good on its promise to bondholders or not, the ramification of recent events is unavoidable: Cautious, even skittish, bond investors, on a municipal or state level.
For decades, government bonds, including municipals, were a good, if boring, investment. Yet recently, wild swings have made them anything but safe or boring.
Since the 1970s, states’ tax revenues have grown at mild rates. Naturally, this didn’t cause alarm when growth was still positive and the global economic environment was stable. Today, it’s a different story.
The map and chart below are helpful in conveying the extent of the problem. You can see most states attempted to run on a 20% plus budget shortfall in 2010. Only two states – Montana and North Dakota – lived within their means.
While the map is a good representation of the breadth of the problem – few states are escaping the crunch – the percentage-change chart below the map is a great representation of the magnitude of the problem.
State tax revenues have become more volatile since 2000. The first swing was from +10% in 2000 to about -5% a few years later. But just as states faced shrinking revenue, tax income shot back up, growing at 10% again by 2005. The relief was short-lived. Tax revenues subsequently contracted by more than 10% by 2010.
Revenue volatility makes annual budget planning an impossible task. “Are we going to have 5% more money to work with? Or, will we have to get by with 10% less?” Those are questions no one can answer, especially not when state tax revenues are so volatile from one year to the next.
The best path forward for states struggling to balance the checkbook is unclear. Regardless, the balancing act will continue to squeeze the average American who can expect to pay more in taxes, and receive less in benefits, over the years to come.
Oh, and bond buyers beware. Investing in municipal bonds is no longer a sure bet. As we’ll continue to research and discuss, municipal bonds are a great investment opportunity, but you must dig in and research well to make sure you’re not stuck with the next Detroit.