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Is the Municipal Bond Market too Big to Save?

Aug 20, 2012
Ron DeLegge

The $3.7 trillion munibond market is poised for chaos. If you think the U.S. government is in bad shape, look at local governments. Plus, they can't print money.

Up until now, investing in municipal bonds has been a calm experience. Politicians and credit raters have assured the public that munibonds are safe. But tremors are appearing.

The State Budget Crisis Task force just released a July 17 report showing how six heavily populated states (California, Illinois, New Jersey, New York, Texas and Virginia) are in fiscal turmoil. “The trajectory of state spending, taxation, and administrative practices cannot be sustained,” said the report. (Video: $3 Trillion Munibond Market is Too Big to Save

The top reasons threatening the fiscal health of these states and others like them are:

• Medicaid Spending Growth Is Crowding Out Other Needs
• Federal Deficit Reduction Threatens State Economies and Budgets
• Underfunded Retirement Promises Create Risks for Future Budgets
• Narrow, Eroding Tax Bases and Volatile Tax Revenues Undermine State Finances
• Local Government Fiscal Stress Poses Challenges for States
• State Budget Laws and Practices Hinder Fiscal Stability and Mask Imbalances

State and local governments spend $2.5 trillion annually and employ over 19 million workers - 15 percent of the national total and six times as many workers as the federal government.

Munibond Basics
Municipal bonds are debt obligations issued by state, city and local governments, pay for their daily operations or to fund specific projects, such as the development of roads, bridges, hospitals or schools.

The income earned on municipal bonds is generally exempt from federal tax, and when purchased by a resident of the state issuing the bond, interest may be exempt from state tax as well. Local taxes, if any, also may be exempted.

The two most common types of municipal bonds are general obligation (GO) bonds and revenue bonds. GOs are unsecured bonds backed by the full faith and credit of the issuing government. These are generally paid off with funds from taxes or fees, and are considered the safest of municipal issues. For that reason, they offer lower yields.

Revenue bonds are issued to fund projects that will eventually generate revenue like a toll road. That revenue is used to pay off the bonds. Because they are considered somewhat riskier than GO bonds, revenue bonds typically offer higher yields.

Red Flags Everywhere
Instead of warning bond investors about the mounting default risks, credit rating agencies have been up to their no good dirty tricks again. Moody’s Investors Service (NYSE:MCO) and Standard and Poor’s (NYSE:MHP) provide annual default statistics showing just  71 and 47 munibond defaults have occurred over the past few decades, while the Federal Reserve Bank of New York shows actual defaults were 2,527. In other words, rating agencies have been understating default rates.

How have bond investors reacted?   

Rather than heeding the warning signs, asset flows into bond munifunds (NYSEARCA:MUB) currently suggests investors are either complacent or ignorant. Through the first half of 2012, investors sunk a$31.56 billion in munibond funds. Not only does the existing pace easily beat last year’s, but it’s 40% more than the record inflows experienced during the first half of 2009-10. Asset flowssuggest an unsustainable peak.

The August issue of the ETF Profit Strategy Newsletter analyzes the $3.7 trillion municipal bond market. We identify key inflection points that will radically alter this mega market. Yes there are warning signs, but there are also opportunities for astute investors.  

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