The Coming Muni Bond Crisis

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After living through the most recent financial crisis, a lot of folks have their eyes peeled for the next big catastrophe. We're not totally out of the woods yet, so it's not surprising many investors are waiting for the other shoe to drop. And it doesn't take too much detective work to see where a lot of people think the next big problem will arise.

Danger ahead
A combination of falling tax revenues and unsustainable levels of spending are leaving many state and local governments in the lurch. Fear of an increase in possible defaults has roiled the municipal bond market in recent months, driving up average muni yields to nearly 5.4% as of Jan. 20, the highest since the worst days of the financial crisis back in December 2008. Perpetually indebted California faces a budget shortfall of roughly $25 billion this year, and some are even predicting default for the Golden State. Many other states face similar challenges and a lot of investors aren't waiting around to see how things will shake out -- in fact, they've been abandoning muni bonds en masse in recent weeks.

Last year, Warren Buffett himself warned that there is a "terrible problem" looming for the municipal bond market. Analyst Meredith Whitney, who earned fame for correctly predicting that Citibank would have to cut its dividend to survive, has made some pretty dire predictions about the sector. She is forecasting 50 to 100 significant municipal bond defaults this year, totaling hundreds of billions of dollars. If her prediction is even partially accurate, that would mean muni bond investors would take a huge hit.

A reasoned approach
While I don't want to make light of the serious problems that many state and major municipalities are facing right now, I just don't see a massive crisis looming ahead. There may in fact be some defaults in the coming quarters, but I don't think we're going to see anything that constitutes a crisis. Muni bond defaults are incredibly rare. According to Forbes, last year there were only six municipal bankruptcies, five of which were for rather small dollar amounts. Furthermore, from 1999 to 2009, only 10 entities are on record as having failed to make debt-service payments, according to Fitch Ratings. Of course, just because mass defaults haven't happened in the past doesn't preclude them from happening in the future. But states have the ability to cut spending and raise taxes to help service debt payments, making mass defaults unlikely.

In fact, given where yields are right now, muni bonds may be even more attractive now for higher tax-bracket investors. Investors have pulled massive amounts of money from the sector in recent weeks, driving prices down and yields up. If default fears prove to be overblown, this could be an opportune time to buy. Bond luminary Bill Gross has gone on record contradicting Whitney's call, saying that while there may be some defaults, he doesn't believe there will be that many of them. According to Gross, "The bottom line is that sky-is-falling reports about the muni market are lacking in evidence." Revenues have begun to climb again as the nation's economy emerges from recession, helping to boost states' coffers. States will undoubtedly need to make painful cuts in spending to make ends meet, but I think investors who are abandoning the muni bond market may end up hurting themselves in the long-run.

Where others fear to tread
Risks will remain elevating in this sector for some time to come, so if you are thinking about dipping your toes in the water here, there are a few things to keep in mind. First of all, take a diversified approach. Since so many states and municipalities are facing increased pressure, you want to spread your bets around to avoid the impact of any potential defaults. This means a muni bond mutual fund or exchange-traded fund is your best bet right now. Here are some ideas:

  • Several national muni bond ETFs fit the bill for general use, including PIMCO Intermediate Muni Bond Strategy ETF (NYSE: MUNI  ) or Market Vectors Intermediate Muni ETF (NYSE: ITM  ) .
  • For those looking for longer-duration bonds, which could gain more if muni bond rates start falling again, iShares S&P National AMT-Free Muni Bond ETF (NYSE: MUB  ) might also work for some investors.
  • On the other hand, if you want a more conservative fund that focuses more on the shorter side, SPDR Nuveen Barclays Capital Short-Term Muni Bond ETF (NYSE: SHM  ) is a good pick.
  • People in high-tax states can benefit from state-specific funds. Investors residing in New York or California might want to consider iShares S&P NY AMT-Free Municipal Bond (NYSE: NYF  ) or iShares S&P CA AMT-Free Municipal Bond (NYSE: CMF  ) , respectively.

Next, keep a focus on higher-quality issues. Now may not be the time to dive into high-yield municipal bonds, so stick with funds that have an investment-grade (rated BBB or above) average credit quality. On the actively managed fund side, Vanguard Intermediate-Term Tax-Exempt (VWITX) boasts an average AA credit quality rating, while American Century Intermediate-Term Tax-Free Bond (TWTIX) clocks in with an A rating . Both funds have fine long-term track records and reasonable expenses for the asset class.

There will undoubtedly be tough times ahead for local and state governments, which will likely flow over into the muni market. However, be careful not to get caught up in the panic and flee this corner of the market if investing in muni bonds makes sense for you. If the U.S. economy manages to right itself, municipal bonds could become a much more attractive proposition.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (6)

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  • Report this Comment On January 27, 2011, at 5:25 PM, rd80 wrote:

    Nice rundown. I agree that muni failures will be rare, but there is potential for one or more big, big issuers to have problems.

    For example, Illinois was recently trying to arrange for investment houses to buy its vendors' accounts receivable because they were past due and the state didn't have the cash to pay. The argument was the late fees of 1% per month created a juicy yield. IL was arguably in default on its obligations and willing to pay 12% per year to paper it over. WSJ article here:

    Now consider the turmoil in the European markets from the PIIGS credit troubles and that Illinois' GDP is roughly one and a half times that of Greece.

    A big state failure may be a low probability event, but IL, NY or CA defaulting or restructuring debt would rumble well beyond the muni markets.

  • Report this Comment On January 27, 2011, at 7:23 PM, bzhayes wrote:

    Thanks for the article. I recently jumped into a CA muni with NCA. I agree some defaults are possible but the kind of catastrophic collapse some people are predicting is overblown. I am worried about a continued rash of sell-offs if people keep getting spooked. Indeed I've already lost 5% on my investment because of it. However, long-term this seems like a great investment. I am getting a 6% return state and federal tax free.

    The comparison to the EU and PIIGS is interesting, but keep in mind, the EU is a week collaboration between governments compared to the US which has a functioning central government. We are much more tied together than individual EU nations are. Its an interesting comparison but it is an apples to oranges comparison.

  • Report this Comment On January 27, 2011, at 11:10 PM, Superdrol wrote:

    I aL

  • Report this Comment On January 27, 2011, at 11:14 PM, Superdrol wrote:

    Messed up my prior post.

    In my personal account I spent a substantial amount of money and bought California bonds. This is with my own money not client money.

    The reason is:

    -Back in 2009 California paid everyone junk IOUs except bondholders. The are not diligent about how to run a state but they do not touch the slush fund for bondholders.

    -California is the 8th largest economy in the world. Their GDP is nearly 2 trillion annually. It attributes to 10-12% of the US overall GDP.

    -Debt servicing (not principal paydown) equates to around 5% of annual revenues that's not a lot.

    -California composes approx. 20% of the municipal market. A default by the would have a ripple effect and collapse the ability for any state to seek funding. All states will be punished due to guilty by association. It's just human behavior.

    -Illinois is more bankrupt than California and by our firms research should be rated BB- or so. Illinois is in a very dire condition and despite having a higher credit rating than California would default first if that indeed would happen.

    -To that point in the rare event Washington tries to show they have a pair and lets Illinois go broke the economy would unravel much like when Lehman Brothers went under. Just like in 2008 Washington tried to be a big boy and let Lehman go then played slave the rest of the time. As I said before Illinois would be the first to go under out of all the states.

    The high yield plus tax benefit makes California bonds for me no brainer. I see very little risk, but that's just my opinion. California is literally too big to fail. The numbers are just too substantial. If the US ever let any state go under it will be 2008 financial crisis x 1,000. That's basically a partial US default and the US itself could lose its AAA credit rating.

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