Share This Article

Facebook LinkedIn
Twitter Reddit
Print Email
Pinterest Gmail
Yahoo
Money Morning
×
  • Invest
    • Best Stocks to Buy
    • Stock Forecasts
    • Stocks to Sell Now
    • Stock Market Predictions
    • Technology Stocks
    • Best REITs to Buy Now
    • IPO Stocks
    • Penny Stocks
    • Dividend Stocks
    • Cryptocurrencies
    • Cannabis Investing
    • Angel Investing
  • Trade
    • How to Trade Options
    • Best Trades to Make Now
    • Options Trading Strategies
    • Weekly Trade Recommendations
  • Retire
    • Income Investing Guide
    • Retirement Articles
  • More
    • Money Morning LIVE
    • Special Investing Reports
    • Our ELetters
    • Our Premium Services
    • Videos
    • Meet Our Experts
    • Profit Academy
Login My Member Benefits Archives Research Your Team About Us FAQ
  • Invest
    • Best Stocks to Buy
    • Stock Forecasts
    • Stocks to Sell Now
    • Stock Market Predictions
    • Technology Stocks
    • Best REITs to Buy Now
    • IPO Stocks
    • Penny Stocks
    • Dividend Stocks
    • Cryptocurrencies
    • Cannabis Investing
    • Angel Investing
    ×
  • Trade
    • How to Trade Options
    • Best Trades to Make Now
    • Options Trading Strategies
    • Weekly Trade Recommendations
    ×
  • Retire
    • Income Investing Guide
    • Retirement Articles
    ×
  • More
    • Money Morning LIVE
    • Special Investing Reports
    • Our ELetters
    • Our Premium Services
    • Videos
    • Meet Our Experts
    • Profit Academy
    ×
  • Subscribe
Enter stock ticker or keyword
×
5 Ways to Beat the Fed (and Crush Inflation)

Email this Article

Send with mail | ahoo instead.
Required Needs to be a valid email
Required Needs to be a valid email
Municipal Bond Forecast: Deadbeat States Emerge as Biggest Threat to Muni-Bond Investors
http://mney.co/1eDjnug
Required Please enter the correct value.
Twitter

Municipal Bond Forecast: Deadbeat States Emerge as Biggest Threat to Muni-Bond Investors

[Editor's Note: This special report on the U.S. municipal-bond market is part of Money Morning's annual "Outlook" series, which has been forecasting the prospects for commodities, U.S. stocks and other top profit opportunities in the New Year. Click on the "Outlook 2011" logo to see past installments.]

By Martin Hutchinson, Global Investing Specialist, Money Morning • January 6, 2011

View Comments

Start the conversation

Comment on This Story Click here to cancel reply.

Or to contact Money Morning Customer Service, click here.

Your email address will not be published. Required fields are marked *

Some HTML is OK

The U.S. municipal bond market could be cruising for a bruising.

The same thing goes for muni-bond investors.

The danger is right out in the open for everyone to see. But investors aren't heeding the warnings.

The bottom line: Avoid the sector, except the very-highest-rated issues; and even then, given the low yields available, there are clearly lower-risk/higher-profit opportunities for your money.

The Birth of the "Deadbeat State"

Municipal bonds - usually referred to as "munis" - have traditionally been very popular portfolio additions 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.

Investors can also more easily keep track of the creditworthiness of their state and local governments.

But there's a problem.

Let's call it the emergence of the "deadbeat state."

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.

These states are 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.

Even so, the municipal-bond market has failed to accurately price in credit risk.

For some perspective, consider this. Long-term bonds issued by Illinois - which is quickly building a reputation as a "deadbeat state" - trade at a yield that is only 2% above that of supposedly super-safe U.S. Treasury bonds. In Europe, by contrast, higher-risk Portuguese government bonds trade at a yield that's 4% higher than solid German Treasury bonds.

This failure by investors to recognize the deteriorating creditworthiness of alleged deadbeat states' risk becomes all the more striking for three key reasons.

First and foremost, the emerging budget crisis in many U.S. states is gaining more and more of the mainstream news spotlight, thanks to recent investigative reports conducted by such media outlets as the CBS News "60 Minutes" news magazine.

Second, given that new governors are taking office in 26 states in the New Year, investors can expect a flurry of headlines about the worst budget climate for U.S. states in a generation. In states such as New York, Illinois, New Jersey, South Carolina and Nevada, there are clearly no easy fixes - even though there's an estimated cumulative budget shortfall of $140 billion for 2011.

And lastly, given the Republican control of the new House of Representatives, the odds of a federal bailout for Democrat strongholds like Illinois and California are likely to be very slim.

The Great Depression vs. The Great Recession

Rating agencies are relatively positive about state and municipal bonds. The lowest-rated state - Illinois - is still A-rated by all three rating agencies.

Statistics on defaults produced by the rating agencies suggest that municipal debt is considerably less risky than equivalent corporate debt. However, those statistics may not continue being true. In the aftermath of the Great Recession, risks on municipal debt may be much higher than historically experienced, and 2011 may well be the year in which that unpleasant reality becomes fully apparent.

At first sight, it is not obvious why this should be so. While the Great Recession has been deeper and considerably more prolonged than any since World War II, it is only modestly more severe than the "double-dip" recession of 1979-82 - if that downturn is considered as a single event.

Further, the rating agencies' default rates include data from the Great Depression. And if you consider the period during which U.S. unemployment exceeded 10%, the Great Depression was actually much worse than the current unpleasantness, as well as lasting more than a decade.

For a number of reasons, however, this recession has been especially difficult for state and local governments, and even bears comparison to that deep 1930s downturn.

During that decade, state and local governments were much smaller and taxed their citizens correspondingly less. It was also a period of careful government budgeting. Hence, during a recession state and local governments could raise taxes without damaging their economic base.

It's a much different time today.

Outlook 2011 In contrast to the careful budgeting of the '20s, the stretch from 2001-2008 was one that saw many state budgets explode in size, lured into expansion by an excess of cheap money.

Hence, the finances of many states - California, Illinois, New York and New Jersey, for example - were already stretched going into this downturn. And that made them highly vulnerable to unexpected economic headwinds.

The housing market may have been the roundhouse punch that finally put local governments down for the count. That had been the backbone of local government finance, had enjoyed a ridiculous boom from 2001-07, and has collapsed in price since.

Except for the Florida land craze of the early to middle 1920s - a speculative frenzy, to be sure, but one that was contained in that region - there was no real-estate bubble heading into the Great Depression.

The Great Depression saw many municipalities default and one state default. That state, Arkansas, was felled in 1933, after having overspent on road projects the decade before (making it an exception to the general carefulness of state governments).

Why "Crunch Time" Has Come

Since the Great Depression, defaults have been few. The largest in the 1979-82 double-dip downturn was the Washington Public Power Supply System, which suffered from the costs of half-completed nuclear power plants.

Ordinary municipalities did not default in any number in the early 1980s, 1990s or 2001-03 recessions, although Orange County, Calif., in 1994 defaulted on debt through costs incurred gambling in the derivatives markets.

The lack of defaults in 1979-82 can be explained by the very rapid economic recovery in 1983, followed by a sharp drop in interest rates and rise in house prices.

That brings us to 2011. This time around, unfortunately, states and municipalities are not so lucky.

What's more, even though the U.S. economy has started to recover, there can be no question that the major state and municipal defaults are ahead of us. The difficulties experienced by states and municipalities in the early years of a long downturn can be covered by reserve funds and by cutting out the ample fat in municipal budgets. In 2009-2010, the Obama administration's "stimulus" further cushioned the downturn's effect.

Here at the start of the New Year, while corporate income tax payments have recovered somewhat, personal-income-tax payments remain depressed - in part because of high unemployment. At the same time, property-tax payments are generally still declining as more homeowners get in difficulty and property valuations are revised downwards.

With "stimulus" payments to state and local governments unlikely in 2011, crunch time has come.

There's still another problem this time around that makes this situation even worse: There's a problem with municipal bond insurance. During the boom, many municipalities issued debt guaranteed by a specialized monoline insurance company, which thereby enabled the debt to be rated AA or AAA.

This seemed a good idea at the time, but many of the monoline insurance companies also specialized in insuring subprime home mortgage securitizations. While their municipal insurance businesses have not produced significant losses, their home-mortgage-insurance businesses have caused them to spiral towards insolvency.

One of the monoline insurers, Ambac Financial Group Inc. (PINK: ABKFQ), filed for Chapter 11 bankruptcy protection in November and others can be expected to follow.

The bottom line is that if municipalities start making substantial claims on their monoline insurers, they may find the money is not there.

For investors, the message is clear. The municipal-bond market isn't accounting for the risks these bonds face. So if the yield on a municipal bond looks attractive, its creditworthiness is almost certainly sub-par.

It's a sector that you want to avoid.

Actions to Take: The municipal-bond market isn't accounting for the risks these bonds face. So if the yield on a municipal bond looks attractive, its creditworthiness is almost certainly sub-par.

Given the low yields currently available on "munis," there are almost certainly better places for your money. If you absolutely feel you must buy munis, stick with the very-highest-rated issues.

Better still - especially given the questionable nature of these ratings - avoid the sector altogether.


[Editor's Note:
If you like the insights that our "Outlook" series provides, but you want to receive this kind of financial-market intelligence throughout the year, you should look at our monthly affiliate newsletter,
The Money Map Report.

Each month, the gurus who write for Money Morning get together and identify the very best profit opportunities. And they do that by "following the money" - spotlighting the global moneyflows that point to very best profit opportunities available at that time.

Sometimes this exercise means "following the money" from one sector to the next. Other times that means moving from one geographic market to another.

To make those moves successfully, investors need a compass or, better yet, a guide. And successful investors will tell you, one of the best guides out there is The Money Map Report.

The Money Map Report employs many of the same experts whose columns you read here each day. The difference is that while Money Morning is news and investment analysis, The Money Map Report is dedicated solely to investment analysis.

Our writers use proprietary money-flow indicators to identify and isolate the most timely profit opportunities you'll find anywhere. For more information about The Money Map Report, please click here.]

News and Related Story Links:

  • Money Morning News Archive:
    News Stories About Municipal Bonds.
  • Money Morning Mailbag Story:
    Money Morning Mailbag: There's No Way Around the Dangers of Municipal Bonds
    .
  • Money Morning Defensive-Investing Series:
    Defensive Investing: Beware of Municipal Bonds
    .
  • Money Morning:
    State Budget Crises Threaten U.S. Economic Recovery
  • Money Morning News Archive:
    News Stories About "Deadbeat States."
  • Money Morning Question of the Week Feature Story:
    State Budget Crisis: Deadbeat States Need to Stop Spending, Start Mending.
  • CBS News "60 Minutes" News Magazine:
    State Budgets: The Day of Reckoning
  • Bloomberg/BusinessWeek:
    New govs take office amid historic budget crisis
    .
  • Wikipedia:
    The Great Depression
    .
  • Money Morning:
    Defensive Investing: Beware of Municipal Bonds
    .
  • Harvard Business School Baker Library:
    The Forgotten Real Estate Boom of the 1920s.
  • Time.com (August 1983):
    Whoops! A $2 Billion Blunder: Washington Public Power Supply System.
  • Money Morning News Archive:
    Question of the Week Feature
  • Radio Station KMOX - News/Talk 1120:
    Illinois: A Deadbeat State?
  • University of Illinois at Urbana-Champaign:
    The Great Depression - An Overview
    .
  • The San Jose Mercury News:
    Opinion: Think the U.S. is finished? It's all happened before.
  • Investopedia:
    Monoline Insurance Company.
  • MarketWatch.com:
    Ambac Financial files for bankruptcy
    .

Join the conversation. Click here to jump to comments…

Login
guest
guest
11 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
felix mosso
felix mosso
12 years ago

Good article, BUT as you say [Avoid the sector, except the very-highest-rated issues] after the
subprime RATINGS issue how can anyone TRUST the rating companies ???????????????
Just say NO to Bonds and wait for the smoke to clear.

0
Reply
Daniel Victor
Daniel Victor
12 years ago

What happens if States do go bust ? How do essential services – such as policing garbage collection,and schools – get paid for ? If it were to happen,they – the US Government,or the State itself,would have to organise something.

0
Reply
Saint Peter II
Saint Peter II
12 years ago

Excellent and timely article. For a while now similar takes on the munis have appeared, but none mentioned the importance of the monoline companies and their precarious financial position. At a time when the Mary Poppins view of the economy seems to be dominant, such an article as this is especially valuable. Free no log-in editorial cartoons with different take on inflation,

0
Reply
warren kapsner
warren kapsner
12 years ago

Sit investments has a Minnesota tax free bond fund. Are funds with mutiple bonds a better bet for investment?

0
Reply
jj
jj
12 years ago

There is good that may come from this if it results is smaller govt.I do know that inflation will be a major problem in 2011 and that will cause the Fed to raise interest rates or risk a run on the Dollar.I don't think higher interest rates are going to be good for bonds.

0
Reply
armando salinas
armando salinas
12 years ago

The next two years will decide if the USA will continue to the dominant world power,
I really doubt that Congress and the President will do what is in the best interest for the nation,that goes for state governments.

0
Reply
P.W.S.
P.W.S.
12 years ago

Do not companies such as AIG and AGO have exposure to a muni meltdown? Their stock price seems to say "all is well and the future is bright"

0
Reply
Victor
Victor
12 years ago

I am a fan of Mr. Hutchinson and a subscriber to his Permanent Wealth Advisory. For the most part, I agree with everything he has stated. The only point I would raise is that, with respect to my home state, California, the cost to service the current bond debt is less than 5% of the State's budget. Furthermore, the State constitution prohibits the State from defaulting on General Obligation bonds (G.O.'s). Lastly, the state is required to pay bond debt BEFORE almost every other expenditure other than public school funding and a few other things. Therefore, I think the risk of the State of California defaulting on G.O. bonds is very slim. That being said, the State's budget (and process) is an absolute mess and I find there are much better places to invest your money …

0
Reply
TW
TW
12 years ago

I would like to know your comments on mutual funds investing in state specific bond funds, i.e. like the question posed by Mr. Kapsner above. I am invested in a T Rowe Price Maryland bond fund (have been for about 20 years)…should I be shifting at least part of my investment to something else?

0
Reply
David
David
12 years ago

This is an poorly researched article, filled with scare stories not supported by the facts. Shame on the author for writing it, but actually thank you for continuing the myth about large scale municipal bankruptices that raises yields so I can buy, buy, buy!

0
Reply
William Patalon III
William Patalon III
12 years ago

David:

I have to say that I'm mystified by your comments. Meredith Whitney, one of the best "non-Wall-Street" analysts on Wall Street — who has predicted previous financial meltdowns — has been studying this for two years and has made highly alarming observations about what's ahead. Even the states themselves….especially now that new administrations have taken over….are making candid disclosures about the mismatches in revenue and expenditures that they see, but have no answers for. The rating agencies are always the last to act, and usually only after the cow's out of the barn.

If that's not enough for the bond market, there's also the fact that we have a major interest-rate issue/challenge here in this economy.

So to say that this was poorly researched and a "scare" story …. well, I'm afraid we cannot agree. If anything, Mr. St. Pierre's comments are more on point that yours.

Still, we certainly welcome the comments, and will continue to do so.

And I certainly wish you the best in in the New Year.

Respectfully;

William Patalon III
Executive Editor
Money Morning

0
Reply
LIVE
Visit Money Morning Live


Latest News

January 19, 2023 • By Money Morning Stock Research Team

These Stocks Could Go To $0

January 9, 2023 • By Money Morning Stock Research Team

The Government Is Pouring $391 Billion Into These Stocks - Buy Now

December 27, 2022 • By Money Morning Staff Reports

6 IPOs in 2023 You Can’t Afford to Miss
Trending Stories
ABOUT MONEY MORNING

Money Morning gives you access to a team of market experts with more than 250 years of combined investing experience – for free. Our experts – who have appeared on FOXBusiness, CNBC, NPR, and BloombergTV – deliver daily investing tips and stock picks, provide analysis with actions to take, and answer your biggest market questions. Our goal is to help our millions of e-newsletter subscribers and Moneymorning.com visitors become smarter, more confident investors.

QUICK LINKS
About Us COVID-19 Announcements How Money Morning Works FAQs Contact Us Search Article Archive Forgot Username/Password Archives Profit Academy Research Your Team Videos Text Messaging Terms of Use
FREE NEWSLETTERS
Total Wealth Research Power Profit Trades Profit Takeover This Is VWAP Penny Hawk Trading Today Midday Momentum Pump Up the Close
PREMIUM SERVICES
Money Map Press Home Money Map Report Fast Fortune Club Weekly Cash Clock Night Trader Microcurrency Trader Hyperdrive Portfolio Rocket Wealth Initiative Extreme Profit Hunters Profit Revolution Warlock's World Penny Nation Quantum Data Profits Live Trading Alliance Trade The Close Inside Money Trader Expiration Trader Vega Burst Trader Flashpoint Trader Darknet Hyper Momentum Trader

Ā© 2023 Money Morning All Rights Reserved. Protected by copyright of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including the world wide web), of content from this webpage, in whole or in part, is strictly prohibited without the express written permission of Money Morning.

Address: 1125 N Charles St. | Baltimore, MD, 21201 | USA | Phone: 888.384.8339 | Disclaimer | Sitemap | Privacy Policy | Whitelist Us | Do Not Sell My Info

wpDiscuz