Will the Muni Bond Crisis Derail the Economic Recovery?

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Ever since the recession hit two years ago, U.S. states have been struggling to pick up the pieces. While no two of their tales are exactly alike, the themes are common: ruined economies, plummeting incomes, and massive debt. Collectively, the Fifty have spent about half a trillion more than their taxes could cover.

Up until now, stimulus funds have staved off collapse, but we're approaching the bottom of the money pot. This spring, $160 billion in federal stimulus will run out, and there's no guarantee that Washington will replenish it. And if they don't, many beleaguered states are in for a rough go of it.

Take California, for instance, with an appallingly low credit rating and a $19 billion budget deficit going into 2011. Or Arizona, forced to sell off its state capitol, Supreme Court building, and legislative chambers. And lest we forget Illinois, spending double its tax revenue, now unable to pay off its debt.

Now that the recession has exposed their fiscal flaws, states are looking for ways to repair the damage. New Jersey, for one, is forcing union concessions to bloated retirement plans and health-care packages. But financial analyst Meredith Whitney thinks the proverbial holes these states have dug may be too deep to climb out of.

While Whitney is fairly certain that the states themselves will be able to cover their debts, it will be at the cost of their cities' and counties' funding--which means that many will be unable to meet their obligations to municipal debt holders.

Up to now, municipal debt bonds have been considered extremely safe investments, widely held by individuals saving for retirement and big banks alike. Meaning that even a few defaults could have a big impact -- and according to Whitney, it will be more than just a few. She forecasts "hundreds of billions of dollars in defaults" in 2011 that could singlehandedly derail the economic recovery.

But could her fears be overblown? Bloomberg News' Joe Mysak, for one, is skeptical of Whitney's claims. "The number [predicted by Whitney] is in the realm of the fabulous," he said. Mysak projects that next year's municipal defaults would only total "in the $5 billion or $10 billion range."

And while Dick Larkin of Herbert J. Sims & Co. concedes that "there will be more defaults," he asserts that it will be "nothing coming close to hundreds of billions of dollars"--and he'll even stake his career on it.

It's too soon to tell if Whitney or the naysayers are in the right. But one way or the other, you may want to keep an eye on this developing story. Here are some exchange-traded funds with an exposure to the muni bond crisis. (Click here to access free, interactive tools to analyze these ideas.)

  • iShares S&P National AMT-Free Muni Bond Fund (NYSE: MUB  ) : The fund seeks results that correspond generally to the price and yield performance, before fees and expenses, of the S&P National AMT-Free Municipal Bond Index.
  • iShares S&P NY AMT-Free Municipal Bond Fund (NYSE: NYF  ) : The fund seeks results that correspond generally to the price and yield performance, before fees and expenses, of the S&P New York Municipal Bond index.
  • iShares S&P California AMT-Free Municipal Bond Fund (NYSE: CMF  ) : The fund seeks results that correspond generally to the price and yield performance, before fees and expenses, of S&P California AMT-Free Municipal Bond index.
  • SPDR Nuveen Barclays Municipal Bond Fund (NYSE: TFI  ) : The fund seeks to provide investment results that, before fees and expenses, correspond generally to the price and yield performance of an index that tracks the United States municipal bond market and provides income that is exempt from Federal income taxes.
  • PowerShares Insured National Muni Bond Fund (NYSE: PZA  ) : The fund seeks investment results that correspond (before fees and expenses) generally to the price and yield performance of The BofA/Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index.
  • Market Vectors High Yield Municipal Fund (NYSE: HYD  ) : The fund seeks to replicate, net of expenses, the Barclays Capital Municipal Custom High Yield Composite index.
  • iShares S&P Short Term National Municipal Fund (NYSE: SUB  ) : The fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the S&P Short Term National AMT-Free Municipal Bond index.

Interactive Chart: Click on the time line to compare the performance of MUB against the S&P 500 index.

Kapitall's Eben Esterhuizen and Alicia Sellitti do not own shares of any funds mentioned.

The Motley Fool has a disclosure policy.

Read/Post Comments (1) | Recommend This Article (4)

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  • Report this Comment On December 29, 2010, at 5:31 PM, Joe4IZ wrote:

    I got out of the muni market earlier this year, as I saw this problem coming on strong. Most states, including my own are in denial about how long the recession is lasting. Underfunded pensions and other liablities are not the exception, but the norm.

    More pain will follow this year, I am afraid.

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