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This episode aired on Bloomberg TV on Aug 1, 2013

G.O. Bonds

Q. So you’ve been at a big Family Office conference and I guess the Detroit bankruptcy was a predominant theme..

A. Munis are a core part of their portfolios… especially GOs, “general obligation” bonds. These have always been considered super safe because, like state or federal bonds, the assumption is that the sovereign has taxing powers that can always be used to fund interest and principal payments.

Q. And, just to draw the distinction, the other type of municipal is a “revenue” bond…

A. Right, often used for a private purpose like a hospital or university, or for a specific utility like water or sewer. These are backed by the revenues of the project, instead of the full taxing power of the municipality. Historically, they’ve been considered much less safe than GOs.

Q. We have a couple of graphs that show just how much damage these GOs have suffered lately…

A. The first one here shows that tax-exempt AAA GOs are now cheaper than taxable Treasuries, a remarkable situation, which is why David Kotok of Cumberland is so bullish on them. The next one shows that the high yield GOs have been beaten up even worse than junk bonds, another historical outlier.

Q. So — these portray a pretty extreme reaction in an asset class that’s always been considered so safe. What’s driving it?

A. First, jus the shock that yes, even GOs can default. But as one speaker at the conference said, it doesn’t do much good to have unlimited taxing power if your population has declined so much that there’s no one left to tax…

Q. So that impacts a city’s income picture, but what about the liability side?

A. That’s the real wildcard. Detroit revealed a problem that a lot of cities have, which is that the accounting methods they use for their pension plans understate the true liabilities by using too high a “discount rate,” a topic we discussed in an earlier buzzword segment. That hid the issue in Detroit until very recently, and so the question is: which other cities share the problem?