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How To Prepare For A State Default

Editor’s Note: This article is the second in a two-part series. Read part one.

So you’re a current or retired state employee. Or perhaps you have a state contract, or you own your state’s municipal bonds for the tax-free income. Though your payments have come on time thus far, you’re worried that the state may default.

What should you do?

Bondholders have a very easy option: Sell your individual municipal bonds and reinvest in a diversified portfolio of municipal bonds. Reinvesting in a fund with multistate issuers will reduce the risk posed by a single state defaulting.

Employees, pensioners and contractors are in more of a bind. The state has promised to pay you, and so far it has, but if it goes into receivership, that could change suddenly. Just as bankrupt companies restructure their financial obligations, municipalities under strain have rewritten employment contracts. Vallejo, Calif., while working through bankruptcy, voided the labor contracts it held with firefighters and other employees. The unions involved claimed that doing so was illegal, but a federal judge, Michael S. McManus, decided that federal bankruptcy law trumped the state labor law they cited.

Though states won’t be going bankrupt, it seems likely that receivership could still leave creditors in a pinch.

Even if states don’t go into receivership outright, state pensions are in some danger. Several states are considering eliminating pensions for new workers in an attempt to cope with severely underfunded pension systems. Others, such as Colorado and New Jersey, have reduced or proposed reducing the cost of living allowances (COLAs) on existing pensions.

If you’re about to retire, consider accelerating all payments due. A healthy pensioner might select a single life annuity, which provides the highest benefit, coupled with additional life insurance to provide for a surviving spouse or domestic partner in the event of a premature death. Regardless, if you’re worried about a state’s continued ability to pay, getting more of your money sooner is prudent. If it is possible to take a lump-sum distribution at retirement, take it. Unfortunately, most states don’t offer their employees this option.

If you feel anxious that a state will default, you might consider ways to profit from such an event, or from market perceptions that it will occur. One way to do so would be by short-selling exchange-traded funds (ETFs) that own municipal bonds of a single state. Shorting is a way to bet that the price of a given investment will fall. A trader borrows shares of a stock (or an ETF) and then sells them on the market. Once the price declines, the trader buys the shares back and returns them to the original owner, pocketing the profit. The short-seller must also reimburse the lender for dividends paid while the shares were borrowed. In essence, this provides a hedge, albeit imperfect, against an increased risk of default.

Here is how it might work. Assume you shorted the SPDR Nuveen Barclays Capital California Municipal Bond ETF (CXA) on Sept. 15, 2010, at a price of $23.25. At that time, California’s financial picture was relatively stable. However, by mid-November, California’s budget worries reappeared in the headlines, which led to lackluster demand for new California debt. On Nov. 15, the security was $21.55. Over that two-month period, the simple price return was -7.31 percent. Two dividends were paid during this period, totaling 0.66 percent, which a short-seller would need to repay to the security lender. So, an investor who shorted CXA over this period would have made 6.65 percent.

This example illustrates how news about a state’s finances could affect an ETF’s price. However, shorting should be used prudently. While buying a security can provide unlimited upside and finite downside, shorting provides unlimited downside and finite upside. In addition, shorting an ETF of an individual state will expose an investor not only to the state’s financial strength or weakness, but also to price changes due to fluctuations in overall interest rates and the bond market in general.

The purest way to hedge against, or benefit from, a state default would be to purchase credit default swaps (CDS). CDS serve as insurance for a bondholder. Owners of swaps pay an annual percentage of the bond amount to be fully insured. If a state misses an interest or principal payment, bondholders with outstanding CDS will be made whole.

You don’t have to own a bond to acquire a CDS on it. In fact, most investors in municipal CDS tend to be hedge funds looking to make a quick buck. The total volume of swaps on California’s unpaid debt reached $8.6 billion in August, which is more than a tenth of the state’s entire debt owed. Despite the fact that California has never defaulted, many investors evidently see reason to place their bets. Unfortunately, CDS tend to be sold in amounts that protect $10 million units, putting them out of reach for most individual investors.

There’s no way around the fact that a state default would be bad for everyone it affects, from investors to pensioners, contract holders to ordinary citizens. But while we can hope for the best, it still makes sense to prepare for the worst. Staying alert to the potential for a state not to meet its obligations can give you some room to plan and some options to explore. When the state turns out empty pockets, you needn’t find yours empty as well.