There is no "Chapter 8" in the U.S. Bankruptcy Code. But like a phantom limb, the nonexistent "Chapter 8"-a proposed option to allow states to default on their debts-is already aggravating the municipal bond market.

The bad news began in November; as the market reacted to the Fed's plan to buy $600 billion in Treasuries over the next eight months, bond prices fell and yields moved up. Then, in late January, The Wall Street Journal estimated that states had $3.5 trillion in unfunded public pension liabilities. A few days later, The New York Times blared "Plans Being Drawn Up to Let States Declare Bankruptcy."

The coverage ignited panic among investors and huge outflows of assets from municipal bond mutual funds. Over the following three weeks, the Investment Company Institute estimated that municipal bond mutual funds bled about $9.5 billion. In the week ended Feb. 2, the funds lost another $1.1 billion. Since November, about $30 billion has flowed out of muni bond funds.

Normally investors love munis. Although the yields are low, so are the risks, and gains are largely tax-free. "Munis are like 'pillow bonds'," says Richard Ciccarone, a managing director and chief research officer at McDonnell Investment Management in Oakbrook, Ill. "You don't have to spend too much time thinking about them. The safety was always assumed."



But the muni flight has pushed prices down and yields up. A standard 10-year AAA-rated municipal bond yielded 3.11% by late January, up from 2.51% in November, says Josh Gonze, co-portfolio manager at Thornburg Investment Management in Santa Fe., N.M.

The bad news began in October with the latest Fiscal Survey of States, in which the National Governors Association (NGA) and the National Association of State Budget Officers (NASBO), painted a bleak picture of state budgets. The market crash drastically cut state revenues from all sources and reduced spending in fiscal years 2009 and 2010-the first time in the report's 31-year history that states have had lower general fund spending two years in a row.

Although the recession ended in the second half of 2009, revenues have recovered slowly. At the same time, demand for state services has increased drastically. Almost every state is constitutionally required to enact balanced budgets, but 23 states forecasted at least $40.5 billion in budget gaps for fiscal 2012 and 17 projected at least a $40.9 billion gap. Not all states had completed forecasts when the report was released.

In 2009, states had a total median unfunded pension and retiree liability of $7.2 billion, up from $4.6 billion in 2005. That represents a 57% increase over four years, Ciccarone says, citing Merritt Research Services data. Revenues have been growing, too, but at a slower rate. In 2009, states had a median revenue growth of $15.3 billion, compared with $13.2 billion in 2005. "Economic growth treats the symptoms, but the disease is growing liabilities," Ciccarone says.

Proponents of a "Chapter 8" solution say that if the federal government created a way for states to default, they could renegotiate pension agreements. They could also gain the consent of bondholders to lengthen the maturities and tweak payment terms.

States would have the latitude to decide when and how to declare bankruptcy, says Leon Barson, a partner at Pepper Hamilton in Philadelphia. A Chapter 8 wouldn't have to override state sovereignty. Barson recalls December 1994, when Orange County, Calif., defaulted on a $110 million bond issuance. In that case, bondholder contracts were renegotiated, but they were not "sliced and diced" to the debtors' disadvantage, he says.



State defaults on outstanding debts are almost unheard of in modern economic history. In 1933, Arkansas buckled under a debt of $160 million, making it the only state to declare insolvency during the Great Depression.

Since then, no state has defaulted on its debt. Indeed, only 54 municipal bonds rated by Moody's from 1970 to 2009 have ever defaulted. Of those 54, only four were city- or county-issued bonds. The other 50 were revenue bonds, secured by individual issuers like hospitals. Those defaults represent 0.1% of issued bonds, Gonze says.

As for the headlines screaming that state bankruptcies are inevitable, the Center on Budget and Policy Priorities (CBPP) published a rebuttal. Authors Iris J. Lav and Elizabeth McNichol reminded readers that states issue bonds to fund infrastructure projects, not fund daily operations. The amount of municipal bond debt outstanding remains within historical parameters, they say.

The oft-cited $3 trillion estimate of unfunded liabilities is based on what is known as a "riskless rate," or the assumption that states' pension trust funds will only return a modest guaranteed amount based on underlying conservative investments. The reality, McNichol says, is that states invest in a mix of assets, including higher-yielding corporate bonds and stocks, and can be expected to generate enough returns over two or three decades to offset the amount that they have to pay into the funds. By that measure, the unfunded liability is closer to $700 billion-a worrisome number for sure, but more manageable than $3 trillion.



State budget dilemmas cannot be solved with accounting techniques alone. But experts point out that there are other solutions. Here's a look at why the bankruptcy case has been overblown in two of the most vulnerable states.

* California. "That state has by most measures one of the top 10 economies in the world," says Jim Colby, global senior municipal strategist at Van Eck Global, in New York. "It has a vast amount of resources that generate substantial revenues. The suggestion that [the state] will declare bankruptcy makes no sense."

One reason is that its debt amounts to less than 5% of its annual gross domestic product, Colby says. Also, the state could come up with ways to cash out equity in its parklands, government buildings and tolls, says Christopher Cordaro, a wealth manager at RegentAtlantic Capital in Morristown, N.J.

* Illinois. The Illinois legislature, with the support of Governor Pat Quinn, acted to reduce its $13 billion budget deficit in January, voting to raise the state's personal income tax temporarily to 5% from 3%, and its corporate income tax to 7% from 4.8%. A proposal to borrow $8.7 billion to pay outstanding bills to service agencies was deleted from the income tax vote, but Gov. Quinn had planned to try again in February.



Not all investors are running for the hills, but many are carefully picking their way around trouble spots. Others say the low prices are an invitation to buy.

Cordaro has placed his clients mainly in short-term corporate bonds for now. Yields there are much more attractive than the 1% that short-term municipal bonds are generating. More bad headlines could even drive up yields.

Colby notes that essential-service revenue bonds-which fund sewer, utility or water projects-derive revenues from specific user fees or other public utility commissions that set specific rate schedules. That slice of the muni bond market will perform better than others.

Advisors might also remind their spooked clients that a "Chapter 8" would require an amendment of the Constitution, which is not likely to happen anytime soon. States have legal and ethical obligations to do whatever it takes, be it raise taxes or cut services, to meet their obligations.

"Some political officials are suggesting the rules be changed to make it possible to change state constitutions," Colby says. "A lot of that is political posturing and right now has no basis in fact." While phantom limbs can be painful, it helps to know they're not real.