Although default rates on municipal bonds have remained extremely low, the outcome of default and its effects on bondholders is evolving in the few cases that do exist. There are two facets to repayment of municipal debt: willingness to pay, and ability to pay. Analysts have believed that municipalities will always demonstrate willingness to pay in order to maintain access to the market at all; i.e., if a municipality ever wants to borrow again, it must pay its bondholders no matter what. Ordinarily, the fact that debt payments are usually a very small portion of a municipality’s budget makes payments a priority even if a municipality enters a fiscal crisis.
In Stockton, CA, which just filed Chapter 9 bankruptcy, this assumption will be challenged. Stockton is proposing a haircut to payments to bondholders in order to put its budget on the right path, espousing a philosophy that all stakeholders should “share the pain”. Through Ch 9, the municipality hopes to force its general obligation debt holders to take less in payments. Most of its GO debt is insured or backed by letters of credit, so most bondholders should not experience a hitch in payments. However, the precedent of seeking court approval for a reorganization plan that contains bond defaults – i.e., that does not place bondholders at the top of the creditor list – is ominous.
We think Stockton is being advised that market access will not be as much of an issue as previously assumed in the event of default. Evidence to the contrary is sketchy, which may support this theory. Corporations usually regain access post-bankrupcty; other troubled municipalities have regained market access fairly quickly, albeit sometimes with state help or with other factors at play. Greece has defaulted more than half the time on its government debt (including recently) but investors still loaned it substantial sums at mere basis points above what Germany paid, until about three years ago. The fact is, markets forget.
Time will tell how this case will turn out. But a decision embracing bond defaults will be particularly bad for California muni holders, and not wonderful news for the muni market generally.