Start the conversation
Comment on This Story
Or to contact Money Morning Customer Service, click here.
Of the speculative excesses that misguided monetary policy and a prolonged recession has caused, the one that poses the most danger to investor wealth is the financial bubble in state and local municipal bonds.
Municipal bonds - usually referred to as "munis" - are very popular portfolio plays because of tax advantages that, in effect, enhance their rates of return. There's also an allure because of their local nature: Investors can invest in specific bond issues that provided the money for projects such as schools, highways, bridges, hospitals or housing that actually affects the community in which the investor lives. That makes them a very tangible investment.
But there's a problem.
State-and-local-government finances have taken a bigger beating during this economic downturn than during any other recession since World War II. Even worse, that beating came after the easy money available during this stretch encouraged those same governments to venture well beyond any reasonable limits in terms of their borrowing. They're now stuck with a bigger-than-warranted debt load - which can't be covered by the property tax stream that's been reduced by record-level housing defaults.
The bottom line: At the present time, "munis" may not be the benign - or even alluring - investment that they've been in the past. In fact, thanks to continued fallout from the worst financial crisis since the Great Depression, some munis may be more akin to bombs than bonds - ticking away and just waiting to blow up your portfolio.
Broken Rules, Broken Budgets
Brokers will tell you that particular state and municipal bond issues are "safe," meaning that they are rated highly by the rating agencies. However, the rating agencies got it wrong on subprime mortgage instruments, and it seems pretty clear that they are getting it wrong on states and municipalities.
Theoretically, state governments should not have this problem. All the states - with the sole exception of Vermont - have prohibitions against running budget deficits. Those prohibitions are in place for a reason: By avoiding deficits during healthy periods, the budgetary strain won't be nearly as severe when tax receipts and other revenue drops off during a downturn.
Unfortunately, states have discovered various accounting dodges to get around the deficit prohibition, meaning the supposed safeguards aren't all that tight.
The state "funding gap" for the fiscal year that began July 1 is $144 billion, which is 8% larger than the $133 billion shortfall for the just-concluded 2009-10 fiscal year.
But the outlook is actually going to get even worse: The federal stimulus spigot gets turned off in December, ending a flow of funds that states had been using to offset their revenue shortfalls and narrow their budget deficits. Make no mistake: The end of the stimulus money will leave a huge funding gap going forward.
In most cycles, energetic economic recovery rescues state budgets, although state budgets typically lag - for example the state budget gap peaked in 2004 after the 2000-2001 recession.
Given the poor current financial condition of so many of the U.S. states, a drawn-out/sluggish recovery - or even worse, a "double-dip" recession - could upend state finances for years to come.
At the municipal level, the primary revenue source - aside from "direct transfers" from state coffers - is local property taxes. Property-tax rates are set as a percentage of home values. When the housing bubble caused stratospheric increases in housing values in the middle part of the decade, property-tax revenue soared in kind - enabling municipalities in thriving areas to expand lavishly.
Since 2007, needless to say, this has all been reversed. What's more, if municipalities respond to declining house prices by jacking up property tax rates, as many are doing, they run the risk of causing a wave of regional mortgage delinquencies.
Homeowners who were already struggling to make ends meet now find themselves facing an additional cash-flow demand that they cannot meet. Some in this predicament may gamely stick with it for awhile, attempting to meet the additional demand in order to keep their mortgage current - before finally succumbing to the inevitable realization that they just can't do it. Others literally walk away from an asset that has declined in value and become a burden.
In either case, the homeowner defaults on their mortgage.
Needless to say, any further decline in house prices following the ending of the $8,000 buyer subsidy will strain municipal finances further.
Muni-Bond Defaults Soaring
Municipalities - like many homeowners - are struggling to make ends meet. Municipal-bond defaults may soar well beyond 2009's $6.4 billion, the most since 1992.
Last year, the state in most difficulty appeared to be California, because of the severity of the real estate decline and because of its dysfunctional state government, in which spending restraint appears to be almost impossible.
This year, investors should turn to Illinois, where the recession has been severe, producing a current unemployment rate of 10.4%. Here the quality of state government is indicated by five of the last nine governors having served prison sentences (not counting ex-Gov. Rod Blagojevich, who's currently on trial.)
Illinois just borrowed $900 million in a bond issue that was very well received, being priced at a yield 0.15% lower than expected. However, that is much more a function of the high yield offered - nearly 7%, or 4% above equivalent U.S. Treasuries - as well as the excessive liquidity in bond markets right now. Much of the demand for the bonds came from foreign institutions, which have a strong preference for government over corporate financing, because they don't understand the risks involved.
In reality, the $900 million bond issue was borrowed to make Illinois's required contribution to its state employee pension fund. This came in addition to a $2.4 billion bond issue earlier this year to fund previous contributions to the pension fund, and an earlier issue of as much as $10 billion in 2003 - for this very same purpose.
Meanwhile, on the spending side, Illinois state spending has risen from $56 billion to $80 billion in the four years since 2006, according to National Review's Kevin Williamson, who has been following this case.
There has been neither a state moratorium on payment since Arkansas in 1933, nor a full default since Pennsylvania in 1841. Nevertheless, the combination of poor-quality state governments, reckless overspending during the boom years, state pension systems that are totally out of control and a deep-and-prolonged recession following a severe housing downturn have lined the stars up for one or more state defaults in the next few years, unless the U.S. economic recovery really gains strength.
Some states, like New Jersey under new Gov. Chris Christie, may be able to drag themselves back from the brink - but it will require Herculean efforts to do so.
Nevertheless, it seems hopelessly unlikely that all the vulnerable states - and there are perhaps a dozen with considerable degrees of vulnerability - will be able to save themselves this time around. Only a few states - such as North Dakota, which is conservatively run, and which has oil-shale and mineral resources cushioning its recession - seem completely invulnerable at this time.
This will all come back to bite investors.
A Once-Benevolent Investment - With Fangs
With interest rates at historic lows (the U.S. Federal Reserve continues to hold the benchmark Federal Funds rate target down near 0.00%), investors have been searching for - and often reaching for - higher yields to boost their returns.
Last year, for instance, investors in that predicament poured $7.8 billion into high-yield municipal bond funds, pushing assets to a two-year high. But they may pay for that aggressiveness this year as default risks grow.
"People are starving for yield because rates are at zero," Paul Tramontano, co-chief executive officer of New York- based Constellation Wealth Advisors, which manages about $4 billion, told Bloomberg News. "They're taking [on] more risk than they think."
As we mentioned earlier, just because brokers say that the muni bonds they're trying to sell you are "safe" because they were rated as such by the credit-rating agencies, those are the same agencies that got it wrong on the subprime-mortgage sector.
They're getting it wrong again on states and municipalities. Avoid the sector.
[Editor's Note: Money Morning's Martin Hutchinson has been on a global hot streak.
Here's what we mean. Just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns - and one is up nearly 25%. He again recommended Korea - which analysts were downgrading - only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.
A longtime international merchant banker, Hutchinson has a nose for profits instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.
With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.
Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll the time well spent.]
News and Related Story Links:
- Money The Permanent Wealth Investor:
Official Website - Money Morning News Archive:
Defensive Investing Series - Morning Special Report:
State Budget Crisis Threatens U.S. Economic Recovery - Bloomberg BusinessWeek:
Municipal Bond Defaults at Triple the Typical Rate, Lehmann Says - Money Morning Special Report:
Has the U.S. Lost its Grip on the Credit-Rating Business? - Securities Industry and Financial Markets Association (SIFMA):
About Municipal Bonds - Bloomberg News:
Defaults Signal Bursting Muni Junk Bubble After Surge - The Washington Post:
Blagojevich's lawyer: Ex-governor never intended to bribe - New Jersey Gov. Chris Christie:
Official Website
Dear Sir,
I have carefully read your article and found it very informative.
I do, however, have 2 relevant questions on the subject matter:
1) Isn't it true that, persuant to the passgae of the Buck Act (1944) and the fact that all states receive annual Fedral Funding , the Federal Government is ultimately liable to secure states debt in case of an unlikely default?
2) Given that all states enjoy the luxury of owning and operating their own Certified CAFR Accounts via which they use hundreds of billions and evern trillions of dollars in equity market, money market, real estate market, ETFs and currency exchange market, commodity market, etc., how can the state manage their wealth (Certified CAFR Accounts) so poorly to run the risk of a default?
I'd really appreciate your reply.
Best regards,
Ben Zadegan
Rather than invest in any one muni, I bougt a closed end fund. Tried to find ones that had a lower % of CA debt, in hopes that if one does default, the others will see the dividend through. But am still watching them closely for any changes in dividends, and so far, they have stayed the same or increased. My understanding is that the municiipalities can now back their dividends with BABs…Is this incorrect?
Municipal bonds pay interest, not dividends-and they pay a fixed amount of interest guaranteed to the bond buyer. As opposed to stocks where you are a shareholder (owner) of the corporation, bonds are a loan/debt in which municipality BORROWS from you and is obliged to pay you back an agreed %%interest rate, and then return your principal. Since bonds are a fixed I.O.U./debt instrument, municipalities do not get to "decide" to pay a dividend, or lower a dividend. If you hold a 6% municipal bond ( or group of 6% bonds in a fund) you MUST be paid 6% interest each year, else the municipality is in default of its bond agreement.
You confuse tax rates with tax bills. If the taxable valuation of a property drops, to produce the same amount of revenue as in the prior year from that property the tax rate would increase but the tax bill would remain the same. By suggesting that the total amount of the tax bill would increase because the properties taxable valuation decreases is wrong and it doesn't matter whether you are talking about a single property or the collection of all the properties in the tax base.
The article does not suggest that tax bills would increase-read what it says. tax RATES would have to increase to compensate for declined property values.
If the quoted text that follows doesn't lead a reader to conclude that rising tax rates mean paying more in absolute dollars why even include reference to tax rates? Why refer to rising tax rates increasing the risk of mortgage delinquincies? Does this not suggest that tax bills would increase?
"What's more, if municipalities respond to declining house prices by jacking up property tax rates, as many are doing, they run the risk of causing a wave of regional mortgage delinquencies.
Homeowners who were already struggling to make ends meet now find themselves facing an additional cash-flow demand that they cannot meet. Some in this predicament may gamely stick with it for awhile, attempting to meet the additional demand in order to keep their mortgage current – before finally succumbing to the inevitable realization that they just can't do it.
Interesting tidbids to sow panic that demonstrates the typical myopia of Wall Streeters to City Hall finances. 1. Annual Muni bond interest expense for the vast majority of public entities is less than 4% of the annual budgets. 2. If a public entity has to reduce operating expenses the muni bond interest expense line item is the last place to look for any real savings. Payroll is where the money is and where the cuts are indeed coming and long overdue. 3. The majority of the current spike in "muni" defaults are coming from junk rated muni bonds issued for developer subdivisions and failed projects that depended on a everlasting commercial and residential bubble. No one with an understanding of municipal finance is surprised by this or is particularly alarmed, except this author. 4. Failure to pay muni interest or to maintain bond reserve funds will permanently damage a public entity's access to muni markets that are essential for the long term viability of a community no politician wants that stain on his watch. 5. Buffet's comments on a dire future for Muni's were particularly selfserving. As a Muni Bond insurer he is looking to cover his own "bets" on the Muni market with a Federal bailout.
This is another scare article with not enough accurate information. I have noticed an increase in these scare articles since the equity markets have proven to be "dry holes" for the past decade. These are often written by people who are "pumping" their own products.
Municipal bonds default less than company debt, Moody's Corp. (NYSE: MCO) said in a February report. The average failure rate for investment-grade municipal debt from 1970 through 2009 was 0.03%, compared with 0.97% for similar corporate bonds, Moody's said. Put another way, municipal bonds, for every default of a muni, there are 32 defaults of an investment grade corporate bond. With those slim odds, why aren't these authors out there protecting us from defaulting corporate bonds?
I strongly disagree with the assumption that Muni's may not the place to be right now. Actually I believe just the opposite. I'll tell several reasons why I feel this way. First of all, there is the supply issue. This was mainly created because of the BaB's (Build America Bonds) which were technically munis but were not tax free, because they were subsidized by Federal money. As a result, tax-free Munis soon became short in supply.
A higher tax environment under the current adminstration is only going to exacerbate this issue, as there will be more and more people seeking relief from Uncle Sam, especially retirees and those in a higher tax brackets. It is very difficult in this environment to find AAA rated munis near 5% (Federal Tax Free yield) without paying a large premium. These are the same bonds that I was able to get at substantial discounts just a year ago.
Then there is the default risk which you were addressing. Only I see it a little differently. When compared to Corporate Bonds the default rates, (according to Moody's report on defaults back in Feb.) are not even close. Investment grade munis' 10 yr cumulative default rates of which four of those years, the country experienced severe recessions, is a paltry .06%. Corporates were 2.5%.
Non-Investment grade munis, during this tough 10yr period did reach 4.55%, but corporate bonds reached 34.01%. I strongly agree that rating research is now more important than ever, but when compared, historically, to the alternatives, Munis are still a very high quality investment class.
Something else that the "talking heads" fail to mention is the fact that 48 out the the 50 states have a "AA" or better credit rating. The other two have an "A" rating. So while the landscape has changed significantly, it is not as dire as the headlines would suggest.
Finally, last year, California wasn't the big problem, it was actually Florida. More than half of the defaults experienced last year were connected to FL real estate, (according to Bloombergs Distressed Securities News Letter.)
I think its time to position ourselves for higher taxes of which Munis are an important part.
Obviously, as an Advisor, I have to study, in depth, the Bond Market. Not many people realize that the Bond Market is about three times larger than the Stock Market They are an important part of most portfolios and as an investment strategy the odds are in your favor.
I'll take those odds any day.
I really enjoy your news letter, even if I don't always agree with it. Keep up the good work!
all your comments are right on i would invest through you LL
Is there a source for determining which states are vulnerable to muni default? There are
rating agencies for just about everything, so I assume one exists for the creditworthiness
of munis by state. Also, not mentioned, but I never buy munis unless they are insured
and have a decent rating (regardless of quicksand rating agencies). A good rating (A or
higher), insured and a strong state history of non-default are "musts" for munis. Depressed
areas, regardless of location, are affected by local economices, whcih are affected by
local taxes, which are affected by unemployment, which are affected by deflation,
devaluation and . . . default!
Great comments, everyone. Even the constructive con
For those readers who have labeled this as an inaccurate, or "scare" article, I suggest that you recalibrate your thinking. I'll give you three articles from three different sources to underscore our point. One is a well-done piece by one of our staff journalists (by that I mean he's not a guy with a product to sell).
The second and third stories were pieces done by Bloomberg News, which, like Money Morning, is a a top-tier financial news and information service.
Take a look.
And remember: Forewarned is forearmed.
Thanks, everyone!
Respectfully yours;
William Patalon III
Executive Editor
Money Morning
http://moneymorning.com/2010/07/16/state-budget-crises/
http://www.businessweek.com/news/2010-07-16/municipal-bond-defaults-at-triple-the-typical-rate-lehmann-says.html
http://moneymorning.com/2010/07/28/municipal-bonds/
Here's the third piece….from BusinessWeek/Bloomberg
W. Patalon III
http://www.businessweek.com/news/2010-03-10/defaults-signal-bursting-muni-junk-bubble-after-surge-correct-.html
great comments…is NYC or NYS in a situation where pension funds have first dibs on tax revenues over bond P&I from creditors in a case of default?…As I think about your answer , how could it that be that I would ever be thinking about this crazieness…maybe it was the GM bankruptsy and the treatment of the creditors by the judge.
[…] Money Morning: Defensive Investing: Beware of Municipal Bonds […]
[…] Money Morning: Defensive Investing: Beware of Municipal Bonds […]
[…] The FT. The truly frightening state of local government finances is sparking heightened concern for municipal bond investors. Investors are scrutinizing "munis" more than ever – and with good reason: Some […]
[…] The FT. The truly frightening state of local government finances is sparking heightened concern for municipal bond investors. Investors are scrutinizing "munis" more than ever – and with good reason: Some […]
The author of this article does not understand the Muni Bond Market at all. I am an individual investor and buyer of Muni Bonds. I will try and set him straight.
So here it is a year later and struggling municipalities are actually reporting revenue increases. The gloom and doom that Meredith W. predicted (and the author of this article seems to share) not only never happened but actually created a huge buying opportunity for muni bond investors.
I have a $600,000 muni bond portfolio consisting of 35 bonds and receive almost $34,000 in tax free income each year. I have never had a default and since most of the bonds are bought at a discount, when they are called (mostly at par or higher) I usually show a large profit in addition to collecting the income.
I am a buyer and holder of bonds for income only…..however I have bonds that I bought during the Meredith W. scare that are now trading at 20% more than my purchase price.
When NY went bankrupt in 1971, they paid all their bonds. The few municipalities that have gone bankrupt recently in California, Alabama and the likes are still making all their bond payments.
Why???????????????? Because bond debt accounts for such a small percentage of a states overall debt that it only makes sense that bond holders get paid first as these same municipalities will have a hard time borrowing money once they get back on their feet if they don't.
I follow a strict strategy when buying bonds.
#1 I buy Investment grade bonds only (including their underlying rating)
#2 I invest small amounts (and average of 10 to 20 K in each bond (never put all your eggs in one basket)
#3 I diversify when buying muni bonds: GO's, Health, Hospital, Universities, Sports arenas, Revenue Utility and etc. I always review the track record of the issuer. Sometimes I even call up the issuers and speak with them.
#4 As an added safeguard, I try to buy bonds that are insured by either Assured Guaranty or National. (over 75% of my portfolio is insured by companies still in business and with a strong balance sheet)
#5 I balance out my muni bond portfolio with a mixture of short, medium and long term bonds with a current yield goal of 5.5% tax free average.
#6 I do use a bond form a well established boutique bond house who I am comfortable with and who has never advised me wrong (even though I check every bond purchase myself)
#7 I combine this bond portfolio with other income stream portfolios that make sense. (just in case there are some defaults) I have a small dividend stock portfolio of Telecom's, Tobacco, Reits, BDC's, Energy, Services, MLP's, High yield ETF's and etc and I currently re invest the dividends. Its a $157,000 portfolio throwing off about a 9.6% taxable return ($15,100).
#8 I negotiate and look for FDIC insured high paying CD's and use the power of larger amounts of money and banks looking to raise capital to get higher rates. I call up the banks myself or have CD locators/brokers that look for these deals. And yes these investments include callable cd's (but with call protection). This portfolio is currently earning an average of aprox 4.60% (taxable) on $230,000. So that's another $10,600.00 in come.
So at just under 1 million dollars I am earning almost $60,000 of which half of this income stream is tax free because of my muni bond investment. So in reality (even at say a 22% tax rate) that brings my income stream to aprox $68,000.
So if you know what you are doing and don't listen to so called experts who say the muni bond market will fail, muni bond investing is safe, and should be a big part of your portfolio if income and safety is your goal.
Hey Joe,
Please help me. You are a smart guy. I am not. I've got 200K I saved up and need a low risk, decent return. (I am single, no dependents, my annual income is 50,000 and I stick 10,000 per year in an IRA.) 5.5% tax free sounds good to me. Who is the boutique bond broker of whom you speak? Do you think he would help me? Thanks. Ernie