States are legally prevented from going bankrupt, but that’s no guarantee they can’t run out of money. Municipalities have no such legal exemptions and, as a rash of defaults from Detroit to Stockton have revealed, more city governments are opting to address their financial problems by taking legal recourse through the nation’s bankruptcy laws.

Over the next decade, the laws and regulations are likely to evolve and play out in the courts in ways that investors cannot presently foresee. But even the ability of states to dodge certain legal technicalities of bankruptcy doesn’t mean they can’t stiff bondholders, as many London investors learned the hard way in 1841 when eight states and a territory called Florida defaulted.

Logic would tell investors that a diverse landscape featuring many robust regions and a panoply of precariously financed ones from Cincinnati to Santa Fe would lead to a highly tiered, stratified market, with creditworthy municipalities paying small yields while more dubious ones face rates approaching those of payday loans. “The gap between Missouri [a balanced budget state] and Illinois is as wide as the Mississippi River is deep,” says Charles Stucke, chief investment officer of Guggenheim Investment Advisors.

Yet when investments and politics collide, logic doesn’t always prevail. Periodic crises in the local market for municipal securities are nothing new, as the experience of European investors in the 1840s and New York City in the 1970s revealed. While Detroit’s bankruptcy earlier this year is the latest and was widely expected, Orange County’s default in 1994 blindsided investors. In contrast to Detroit, Orange County was one of the most prosperous in America.

The municipal market treated each of these crises as isolated, unique events. New York City was viewed as a case of fiscal irresponsibility, as was Detroit.

Unlike the Big Apple, much of the Motor City’s problems could be attributed to population loss and the long-term decline of the U.S. auto industry. Orange County’s default, blamed by many on the Orange County treasurer’s excessive reliance on an aggressive investment strategy advocated by Merrill Lynch, roiled the markets at the time. Experts thought back then that the muni market would reprice different issues and yields would start to widen based on credit quality. Instead, financial engineers expanded the adoption of bond insurance dramatically, and just the opposite happened as credit spreads narrowed.

Before the financial crisis, about 50% of the entire municipal bond market was insured, but the seven leading insurers of the pre-crisis era are barely functioning; today, only about 10% of the market is insured. According to Nick Venditti, portfolio manager at Thornburg Funds, there now are only two truly viable muni insurers, National Public Finance Guaranty, the old MBIA, and Assured Guaranty. The others are at various stages of death struggling to make what payments they can on claims.

Today, the two viable insurers have become very credit-sensitive—few hospitals could purchase bond insurance at present. Venditti suspects troubled states like New Jersey and Illinois could “persuade Assured Guaranty to give them some kind of insurance [on general obligation bonds] at the right price.”

All the bond insurers exist at the mercy of the ratings agencies. Since Moody’s toughened its standards, both of the active insurers stopped paying the agency.

Puerto Rico could be the next shoe to drop. Probably the biggest elephant in the room is the legacy exposure that the insurers have with the island territory.

Venditti estimates that Assured Guaranty has $6 billion in Puerto Rican exposure and $12 billion in claims-paying capacity while National Public Finance Guaranty has $5 billion in exposure and only $6 billion to pay claims.

Virtually all observers believe that municipal bonds, a favorite of both high-bracket investors in high-tax states and retirees, will remain viable investments. But the question they are asking is, which bonds and at what price. Needless to say, the dicey nature of many issuers prompts many to view indexing as a patently flawed strategy for investing in the asset class.

On a national level, the overall health of state and local municipalities has improved noticeably since the financial crisis, says Mark Freeman, CIO of Westwood Holdings Group. Many states have initiated significant budget cuts, and revenues are now improving as income levels slowly rebound, translating into higher sales taxes.

However, the long-term crisis is coming home to roost as the bill for post-retirement pension and health obligations for a wave of state and municipal workers comes due over the next decade. In many cases, these obligations will come with long tails attached to them, since most government entities allow employees to retire and start collecting benefits at much younger ages than the private sector does.

At the moment, the municipal bond market is focused on the near term—municipal bonds yawned at Detroit’s bankruptcy but tumbled with the rest of the bond market in July and August—not on what conditions will look like a decade or two from now. That will change, Freeman thinks. “The market will eventually take pension liabilities into pricing [decisions] on a case by case basis,” he says.

The looming pension crisis is fraught with so many problems that Moody’s Investor Services is establishing a new ratings model that will center primarily around pensions. A handful of states including Illinois and New Jersey are “woefully underfunded,” notes Lee Partridge, chief investment officer of Salient Partners, which manages more than $18 billion out of Houston.

State courts in California and Michigan have sided with pensioners over bondholders, flying in the face of the conventional thinking that certain municipal securities like general obligation bonds were virtually sacrosanct. “California would have to open its jails before it could default on GOs,” one observer remarks.

Many investors are hoping the battle over which party receives priority in municipal defaults like Stockton and Detroit is resolved in the U.S. sooner rather than later so that some degree of clarity emerges. But the problem doesn’t simply revolve around who goes to the front of the line after an entity defaults.

For more than a decade, Robert Arnott, CEO of Research Affiliates, has been sounding the alarm about the required assumptions underlying public pension funding employed by the actuarial community. The bylaws required by pension accounting force actuaries to rely on historical returns for equities. “Why would anyone assume that the next five years will look like the last years?” Arnott asks.

Until recently, most public pension actuaries have utilized an ultra-aggressive rate of return of 8% on stocks, bonds, real estate and other alternative investments.

If there is any lesson to be learned about historical equity performance, it’s that extended periods of poor returns tend to be followed by extended periods of superlative results. The trend can be your friend for longer than anyone might reasonably expect—until it isn’t.

Some public pensions are starting to lower return assumptions modestly to 7.5% or even 7%, but Arnott believes they simply are paying token lip service to a changing reality. In his view, “4% is a sensible discount.”

For many investment experts, the 4% figure would appear excessively conservative, but the implications of those return assumptions are dramatic. Take a relatively well-run city like Milwaukee, which one estimate claims is just slightly overfunded with 102% of the assets necessary to meet its pension obligations.

“I hate to pick on Milwaukee, but going from a 7% to a 4% rate [of return assumption] would take them from 102% to somewhere between 60% and 70%,” Arnott says. So just imagine what it means for states like Illinois and New Jersey that are underfunded by at least 50%.

Ultimately, there are only three ways municipalities can extricate themselves from pension shortfalls. They can: 1) cut pension benefits; 2) combine an increase in employee contributions with higher taxes; 3) eviscerate public services.

California spends more on jails than it does on education, but it’s hard to see affluent residents tolerating some combination of higher taxes at the same time the state empties its penitentiary facilities. As Milton Friedman once observed, the only thing more mobile than the wealthy is their money.
It’s also difficult to imagine retired state workers calmly accepting reduced pensions without the threat of bankruptcy and/or shared sacrifice from other parties. No matter who takes the hit, there will be personal tragedies involved.

Hard choices seem inevitable. Chicago’s public schools recently laid off 2,100 employees partly to finance a $400 million increase in pension expenses. And municipal bond fund managers are encouraged that, if nothing else, Detroit’s bankruptcy appears to be serving as a wake-up call to government workers elsewhere.

Over the very long term, cities and states will move to a less tenuous system where modest defined benefit plans are managed in tandem with more generous defined contribution plans that allow public employees to retire comfortably with a much larger share financed with their own dollars. But in the next decade, a train wreck is coming and it’s unlikely to unravel in slow motion. Municipal bonds will implode “in bursts, not in synchronous intervals,” Arnott predicts.

Privately, experts in fixed income are already debating whether one entity, the state of California, isn’t too big to fail. It represents the eighth largest economy in the world, though it used to be sixth. An insolvency in the Golden State could have global implications and the Federal Reserve Board has the ability to purchase municipal bonds.

But a California bailout would be both unpopular and impractical. “Who is going to bail out California?” asks Arnott. “New Jersey? New York? Illinois? Texas?” You get the picture.