There are several bad examples in municipal finance — Illinois & Kentucky for example, but the worst is Puerto Rico. What is one way that you can tell that things are bad? People are leaving Puerto Rico, and generally they are those that are better off.
Quoting from the article:
Seven years into a grinding downturn, Puerto Rico is experiencing a historic exodus of residents fleeing the island’s battered economy and rampant crime. From 2000 to 2010, a net 288,000 people left for the U.S. mainland, according to the Puerto Rico Institute of Statistics. The pace has accelerated in the past few years as the economic situation has worsened, with a net loss of 54,000 migrants a year in 2011 and 2012 on an island of just over 3.6 million people. Preliminary data for early 2013 suggest the outflow is still strong.
The U.S. territory also is grappling with $70 billion in debt, ratings firms have downgraded its bonds to one notch above junk and investors fear it could default on its obligations.
When more than 1% of your population is leaving annually, you know something is wrong. My main point here is not criticizing Puerto Rico, though. It is part of a broader paradigm. Badly managed states and municipalities will lose businesses and population, making them even less able to service debts. It is akin to Matthew 25:29:
For to everyone who has, more will be given, and he will have abundance; but from him who does not have, even what he has will be taken away.
Jesus was not speaking about municipal financing, but the similarity is that those who do well will get more, and those that do badly will get less.
Several years ago, I was driving to visit my parents in Wisconsin. As I headed into Illinois, I saw billboards encouraging businesses to move to Indiana or Wisconsin. Municipal finance is unstable, because there is the incentive for people and businesses to move to municipalities where taxes are lower, and finances are better-managed.
We will see some states and municipalities fail financially over the next 25 years. I can’t see how it could be otherwise. And in the process, municipal bondholders, and pensioners will take losses.
So watch over your municipal bond portfolio, and avoid areas of the US where finances are badly managed.