Small-Fry Munis Likely to Struggle

By MARK GONGLOFF And IANTHE JEANNE DUGAN

At a time of voracious market appetite for traditionally safe municipal bonds, some market watchers are warning municipal-debt investors to be choosy.

A still-struggling economy is squeezing municipal budgets across the board, but many larger governments are passing on their pain by choking off the flow of cash to the local level. As a result, some warn, there is a rising risk that smaller issuers of municipal bonds, such as towns, schools and hospitals, could strain to pay their debts.

"I prefer large states and cities, as problems within those areas are pushed to local governments," Larry Fink, chief executive of BlackRock Inc., the world's largest money-management firm by assets, said in an interview. "State general-obligation bonds are OK, but not small local bodies."

Mr. Fink's comments reflect a growing skepticism about the traditional safety of municipal debt. Across the country, revenues are declining, but expenses aren't. And public entities are wrestling with how to keep making payments on muni bonds, raising worries about rising risk.

"The assumption that an investment-grade rating is merited for all municipal debt is less tenable every day," said Kenneth Buckfire, CEO of investment-banking firm Miller Buckfire & Co. "This is eerily reminiscent of the early days of the subprime crisis, where everybody was comforted by the investment-grade ratings but nobody did any analysis."

Like Mr. Fink, he believes that states generally have a better chance of weathering the storm. He adds that smaller states would be more vulnerable than larger ones because they have fewer sources of revenue and less control over their budgets. He also is optimistic about debt issued by authorities providing public services such as ports and toll roads. These so-called revenue bonds, he says, would likely be less vulnerable to revenue shortfalls because they are collecting fees for services.

Showing the dichotomy, New Jersey Gov. Chris Christie, trying to close a $10.7 billion state budget deficit for the coming year, this past week proposed cutting $466 million in aid to local governments and $820 million in aid to local school districts.

Investors' interest in municipalities of all sizes and shapes is keen. Nearly $69 billion flowed into long-term municipal-bond mutual funds in 2009, up from about $8 billion in 2008 and $11 billion in 2007, according to the Investment Company Institute. Over $12 billion has been poured into muni funds so far this year.

Muni bonds of any size are typically among the safest investments available. Since last July, there have been 171 municipal default notices filed totaling about $5.3 billion in bonds, representing just 0.19% of the $2.8 trillion muni market, according to Municipal Market Advisors.

"For the most part, these are really resilient credits, and they know what they need to do to maintain access to the capital markets," says Tom Kozlik, municipal-credit analyst at Janney Capital Markets in Philadelphia, which underwrites muni bonds.

Of the 171 defaults, all but one were in riskier muni bonds, such as those backed by land or casinos, Mr. Kozlik notes.

But losing assistance from higher up the food chain means local governments may be forced to trim services, lay off workers or raise taxes to close their budget gaps. Such actions could hurt the local economy and their ability to raise revenues.

Many local governments already tightened their belts during the recession and may have little room left to maneuver. That may leave them more vulnerable to default in the event of an unexpected cash crunch.

Smaller issuers make up the majority of municipal-bond deals. This year, issues of $20 million or less have made up 67% of the total number of deals, based on Thomson Reuters data.