Muni bond holder? Watch for a possible Illinois credit downgrade

Holders of municipal bonds, watch the state of Illinois carefully in the next few weeks.

It's considered almost a given that major credit-rating agencies will downgrade Illinois to "junk" status, meaning non-investment grade. That could prompt bond-fund managers and pension funds to sell out of the state's credit if they can't hold junk bonds in accordance with their investment mandates.

Why should the rest of America's muni investors care? No U.S. state has ever been rated below investment grade, thus Illinois bears watching for the effect a downgrade would have on other states' municipal bonds.

Jon Smith, of DT Investment Partners in Chadds Ford, put Illinois in context: He deliberately does not own Illinois general obligation (GO) bonds, nor does he own municipal bonds issued by Connecticut, New Jersey, or Puerto Rico, which defaulted recently.

"If Illinois goes to junk status," Smith said, "investors holding Illinois bonds will get hammered on the price, and it could cascade into other state muni bond prices," such as Connecticut's.

In addition, the bond-rating agencies have been slow to downgrade in a timely fashion. (Remember the Great 2008 Credit Rating Scandal, in which many agencies rated subprime mortgages "AAA"?)

"Connecticut is the nation's second-worst state in terms of pension liability, and yet they are still rated A-plus" by most credit-rating agencies, Smith noted.

"With many baby boomers entering or already into retirement, muni bonds are usually a big piece of their portfolio, and they have no idea this is happening. You can't just blindly buy laddered muni bonds" as in past decades, he said.

It's instructive to look at what happened to Detroit bonds after the city filed an $18 billion bankruptcy and restructured its pension obligations. Bondholders received 75 cents on the dollar, and pensioners 85 cents on the dollar, Smith estimated.

"The city emerged out of bankruptcy, but Detroit bonds are still trading at high yield," or junk-rated levels, he said.

The federal government can print more money and operate under a deficit, but states can't – they are required to balance their budgets. Illinois hasn't had a budget in three years.

Many muni bond investors buy state GO bonds, but Smith prefers high-quality revenue bonds from hospitals, colleges, and utilities.

"The new rule is buy Children's Hospital of Philadelphia bonds, or University of Pittsburgh and Villanova University bonds, Delaware County, Bucks County Water & Sewer, or even Pennsylvania bonds," Smith said. "The state finally passed a budget, and there's a bill to increase the retirement age going forward" to reduce pension obligations.

"I still believe in Pennsylvania because it's a growing economy, and the state has tools to get out of a deficit by increasing taxes," he said.

Plus, muni bonds are no longer generating the fabulous income they did in the past. Historically, muni bonds have traded at a discount to Treasuries, and today a one- to five-year muni bond trades at about 70 percent of a similar maturity Treasury. A five-year muni generates about 2.25 percent yield, while a corporate bond generates more income, even after taxes, Smith noted.

"Buy corporate bonds, and you may get more income after taxes," he said.

The Consumer Financial Protection Bureau last week released a report on how student-loan servicers deprived borrowers working in public service of debt relief.

If you're in the military or work as a teacher, social worker, public defender, nurse, doctor, or police, firefighter, or other first responder, you're eligible for debt forgiveness of direct student loans after 120 timely monthly payments, under the Public Service Loan Forgiveness program created by Congress in 2007.

But according to CFPB Director Richard Cordray, loan servicers deliberately stall when it comes to helping workers apply for this program. One borrower, a veteran, reported that his loan servicer failed to tell him he needed to consolidate his loans to be on track for loan forgiveness until after he left the military, which meant none of his military service counted.

"Servicers are giving them the runaround in ways that can hamstring their progress. And they do not receive timely or accurate information about eligibility for this program, even when they identified themselves as public-service workers. This can … lead to months or even years of unnecessary payments that can cost thousands of dollars and extend their time in debt," Cordray said in a statement.

Nearly two-thirds of borrowers earn less than $50,000 per year; the average loan amount is $70,000, according to 2015 figures cited by the CFPB. To learn more about the program, go to consumerfinance.gov.