How Politics Makes the Difference Between Municipal and Corporate Bonds
Many of the factors that analysts consider when evaluating the credit quality of a municipal-bond issuer are similar to those used in corporate-bond analysis. These include the sources of the issuer’s income, the strength of its balance sheet, its vulnerability to changing economic conditions and the quality of its budgeting and oversight processes. Corporate analysts must focus on stock repurchases and the potential for a merger or acquisition, while municipal-bond analysts must pay close attention to politics. While the fortunes of corporations can sometimes rise and fall due to the actions of policymakers, the political risks that corporate bonds are exposed to are smaller than those of municipal securities issued by government entities that are creations of the political process itself.
Unlike countries where national governments provide most public services, the US is a federal system with a complex and decentralized structure of states, counties, cities and public agencies, which may issue bonds to fund capital projects and which are usually headed by elected officials. Understanding the unique political dynamics of these issuers and how they affect creditworthiness is essential for investors who are considering allocations to US municipal bonds. Gaining this knowledge requires painstaking fundamental research by managers, rather than mere reliance on rating-agency reports or financial statements.
While financial managers employed by governments seek fiscal stability, budget flexibility and lower borrowing costs, they must balance these objectives against the competing political priorities of elected officials. These may include cutting taxes, minimizing fare hikes or improving services that result in lower revenue or increased spending. The tension between maintaining fiscal restraint and providing constituents with services is designed to be reconciled through an established budget process. In practice, however, political agendas can also influence the decision-making process. Understanding the confluence of these rival priorities is a key corollary to the financial analysis performed by municipal- credit analysts. For example, the margin of support from voters or municipal officials for an initiative can give insight into the priorities of the community.
Regardless of their state of fiscal health, cities, towns and school districts must always balance many competing demands in their budgets. Parents want more educational programs, property owners want lower taxes, and municipal workers want job security and retirement benefits. All tend to be organized and vocal in expressing these wishes.
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