As creditors including municipal bond holders worry about how to protect themselves from the impending bankruptcy of San Bernardino, Calif., separate account bond manager Asset Dedication is telling clients not to panic.
Steve Huxley, Asset Dedication’s chief investment strategist and founding partner, says there will likely be panic selling in the coming days as San Bernardino makes its next move, deciding whether to file for Chapter 9 bankruptcy immediately or use the state’s mediation process.
But investors needn’t worry about losing their principal and interest because San Bernardino’s bonds are insured. “A lot of investors don’t exactly know how these things work,” Huxley told AdvisorOne in an interview. “It’s just not common knowledge” at the retail level that municipalities buy insurance against default, Huxley added. So as long as the insurer can pay, investors should remain calm.
Fears over municipal bond insurance would only be relevant in a scenario of cascading municipal defaults, of the kind the analyst Meredith Whitney has forecast. “It is a possibility that we could be seeing just the tip of the iceberg now, Huxley says. “I would say the probability of municipal Armageddon is in the 1 in 5 range; [Whitney’s] probably at greater than 50%.”
Even with a 20% chance of large-scale defaults, investors must be wondering what measure they can take to protect themselves. The first step, Huxley says, is awareness. “Although the tax-free element of munis is certainly beguiling, one has to be aware of the fact that some of these municipalities fail.”
The solution, he says, is to buy only the highest quality, safest bonds obtainable. Huxley says the investment analysis should include the rating of the insured bond and also its underlying value—that is, the rating the bond would have if it were not insured.
Asset Dedication provides advisors with a retirement income strategy and creates calibrated bond ladders to ensure the advisors’ clients will have the income they need in retirement.
San Bernardino, like Stockton, Calif.—the biggest U.S. city to declare bankruptcy so far—and other failed municipalities did not take in enough revenue to be able to meet its financial obligations, especially its costly payroll and pensions for police, firefighters and other city workers. Another shock was the revelation that San Bernardino city budget officials were not turning in honest numbers in 13 out of the past 16 years, showing surpluses when the budget was actually experiencing a deficit.
Huxley says San Bernardino, like many other municipalities and the state and federal government as well, simply “have to learn to spend less money. San Bernardino was trying to do that; they just didn’t do it fast enough or deep enough.”
The Asset Dedication founder says tax revenues won’t pick up nationwide until an economic malaise similar to the one that bogged down the economy in Jimmy Carter’s time lifts. The source of the malaise, he says, is bad advice the president is getting from “old-time Keynesians.”
Huxley says the deepest source of current political-economic woes is gerrymandering. “They say ‘politics is the art of compromise.’ I think that art has been lost. Congressional districts have been gerrymandered so much that voters elect people that are hardened in their positions. If we let the chips fall where they may [in redistricting] there’d be compromise [and politicians would not] maintain their rigid positions.”
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