Consumers aren’t the only ones who need to worry about their creditworthiness. Several major U.S. cities—including Chicago, Detroit and, most recently, Dallas—have seen their credit ratings downgraded in recent years in the face of escalating pension obligations.
The challenge generally stems from demographics: Because people are living longer, municipalities must set aside more than originally anticipated, eating into funds available for other costs—including debt payments. However, Cooper Howard, a Schwab senior fixed income research analyst, believes the danger is likely to be limited. “While some municipalities may struggle to make payments, we don’t expect widespread defaults due to underfunded pensions,” he says. “And not all municipal bonds are affected to the same degree by pension liabilities. Some munis are legally backed by a dedicated tax pledge as their source of repayment.”
Even so, Cooper suggests the following four actions to help reduce pension-related risk:
- Keep an eye on credit ratings: These have historically been an excellent indicator of a muni issuer’s ability to meet its near-term debt obligations. More-conservative investors will want to stick with munis rated A or better.
- Do some digging: Read through muni bond issuers’ recent disclosures, financial statements and notices of material events. Also monitor bond-rating reports to glean whether governments are tackling pension problems or postponing action.
- Consider professional management: If you don’t have time to monitor the credit conditions of multiple issuers, consider partnering with a professional manager—or investing in a muni-bond mutual fund or exchange-traded fund.
- Diversify your holdings: Avoid too much exposure to a single municipality. Cooper suggests owning at least 10 individual issuers with different credit risks. Alternatively, “bond funds are generally diversified, mitigating the impact of any single issuer,” he says.
The bottom line: If you own munis, keep an eye on their creditworthiness for signs that pension obligations may compromise their ability to pay.
What you can do next
- To research muni bonds and read through recent disclosures, material events and financial statements, log in to Schwab BondSource®.
- Need help researching muni bonds for your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982.