Troubling News for Municipal Bond Owners?Submitted by Bernhardt Wealth Management on April 22nd, 2019
Many investors in higher tax brackets utilize municipal bonds as a portion of their holdings for one simple reason: the interest from bonds issued by state and local authorities is exempt from federal income tax. Further, such interest is exempt from state income taxes imposed by the state in which the bonds are issued.
Bonds issued by the U.S. territory of Puerto Rico carry this benefit a step farther—interest on those bonds is exempt, not only from federal income tax, but also from income tax of any state in the Union. So, an investor living in New York, for example, where state income taxes are fairly high, can buy a Puerto Rican bond and avoid paying state or federal income tax on the interest earned. This has made Puerto Rican bonds very popular.
But Puerto Rico is in deep financial trouble, which has resulted in the bonds issued by Puerto Rican entities being downgraded below investment grade by Moody’s and Standard & Poor’s. Recent devastation caused by Hurricanes Maria, Harvey, and Irma have only made matters worse. In May 2017, the territory was placed under bankruptcy protection as it attempts to restructure its debt.
One ray of hope for holders of certain types of Puerto Rican bonds still existed. Bonds secured by special revenue projects—such as toll roads, water utilities, and other public works that generate ongoing revenue from means other than taxes—were generally believed to be more secure, since the underlying projects had money coming in. Holders of such bonds believed, therefore, that their interest would continue to be paid, in contrast to general obligation bonds, which are backed by the taxing authority of the bond issuer.
But a recent court decision in the U.S. First Circuit has cast a significant shadow over the hopes of revenue bond holders. The court upheld an earlier decision by the judge overseeing the bankruptcy that issuers of Puerto Rican revenue bonds were under no obligation to continue paying interest on the bonds, due to the protections extended by the territory’s Chapter 9 bankruptcy status. The plaintiffs in the case were unpleasantly surprised by this decision and have suggested they are considering an appeal to the U.S. Supreme Court.
This development could have implications beyond Puerto Rico. Given the current state of the ruling, bondholders and rating agencies are looking closely at other state and municipal entities with less than stellar credit. For example, the City of Chicago’s general obligation bonds are rated at less than investment grade, but its water revenue bonds have enjoyed more favorable ratings—up until now. If the issuers of revenue bonds cannot be required to maintain interest payments in the event of a bankruptcy, holders of Chicago water revenue bonds could see their holdings downgraded in quality.
Nationwide, around $1.2 trillion in revenue bonds have been issued, and not all of these bonds are experiencing financial stress. But if the ruling by the First Circuit stands, future bond issuers of all types may be forced to pay higher interest rates in order to attract buyers.
Therefore, you will want to watch this matter closely and review your individual municipal bond holdings as time progresses.