General Obligation Bonds Were Never Risk Free

You may have seen an article on the front page of The New York Times business section on December 23, "Bankruptcy Filing Raises Doubts About a Bond Repayment Pledge". In our view, it is inflammatory. Below, my colleague Joseph Rosenblum offers a more balanced approach.

The article’s basic thrust is that the bankruptcy filing by Jefferson County, Alabama, raises, for the first time, questions about the full faith and credit of a municipal general obligation bond. The implication is that such bonds offered guaranteed repayment and that when Jefferson County stops payment, bondholders will be in for a surprise.

While municipal bankruptcies are extremely rare, general obligation bonds are not—and never have been—risk free. No one should expect general obligation bonds to be guaranteed in bankruptcy or expect a municipality to raise taxes to whatever level is needed to repay its general obligation bonds.

In fact, Chapter 9 of the US bankruptcy code provides a mechanism for a municipality to work out its problems. It includes a plan that might mean less than full repayment. There is a history of such events, although it is limited.

It will be up to Jefferson County, with some input from creditors and the judge, to decide how it wants to treat its bondholders. They can opt to repay the bonds in full or in part, or to stretch out repayment over time. Clearly, the county will need to bear in mind that it will need to return to the markets at some point in the near future.

The credit quality of general obligation bonds, as a class, remains quite high because most state and local governments are required to balance their budgets every year. Most state and local governments have made progress in addressing their budget shortfalls in recent months.

While there are large differences in how state and local governments are handling their financial difficulties, we expect the volume of defaults in the municipal bond market to remain extremely low.

Weak tax revenues may, however, continue to raise investor concerns about the credit quality of some municipalities, putting downward pressure on their bonds. As a result, we believe it makes sense, in the current environment, to underweight state and local general obligation bonds and overweight revenue bonds.

As we have written before, revenue bonds tend to hold up better than general obligation bonds in a weak economy because revenue bonds are backed by fees for essential services such as electricity and water. However financially pressed, the vast majority of people continue to pay their water and electric bills. Thus, the revenues that back these bonds are less sensitive to the pace of economic growth than the property, sales or income taxes that back general obligation bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

This post contains links to third-party websites. AllianceBernstein is not responsible for nor does it endorse the content on these sites.

Douglas J. Peebles

Chief Investment Officer—AllianceBernstein Fixed Income
Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer and Head of AllianceBernstein Fixed Income. In this role, he supervises all of the Fixed Income portfolio management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within Fixed Income, including director of Global Fixed Income from 1997 to 2004 and co-head of AllianceBernstein Fixed Income from 2004 until 2008. He holds a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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