by Richard Lehmann
Investors moved $69 billion into municipal bond funds last year. Don’t follow the lemmings into these future default traps.
The municipal bond landscape has changed substantially since the financial crisis, and not for the better. The problems began in late 2007 with the downgrading of the bond insurers. These firms-Ambac ( ABK ), MBIA and others-collected insurance premiums from smaller issuers of tax-exempt bonds to guarantee the bonds against default. This insurance made the bonds more salable by giving them a ratings upgrade to AAA.
The system worked beautifully until the insurers veered off into the business of guaranteeing exotic credit derivatives on mortgages and other debt. Losses there impaired the insurers’ balance sheets, so the debt they insured lost its automatic AAA rating. Thus, a muni market dominated by interchangeable AAA credits became a bazaar where you now have to know a lot more about the obscure sewer authority or airline that is borrowing the money.
In the past year the muni market has seen a strong rebound. Helping out: the realization among savers that the new Big Government politicians are going to jack up income taxes. That makes U.S. Treasury bonds relatively less attractive. Last year saw $69 billion of net inflows into tax-exempt bond funds.
Don’t follow the lemmings into muni funds. This sector is going to see a lot of pain, and it has nothing to do with federal tax brackets. It has to do with the fact that states and cities are having trouble paying their bills.
Defaults on tax-exempt bonds are the highest since my Distressed Debt Securities Newsletter began tracking defaults in 1983. In 2009, 183 issuers defaulted on $6.3 billon in tax-exempt debt. The majority of these defaults involved entities with taxing power (like the 99 Florida Community Development Districts). It’s only a matter of time before you start seeing defaults on the general obligation debt of state and local governments.
Lavish government pensions are the problem, as FORBES has well documented. Policemen, firemen and jail clerks retire young and collect inflation-adjusted pensions. There is far from enough money set aside to cover benefits already earned. The result is that the government employer will find itself paying two cops instead of one: the one who is now pounding the pavement and the one who was doing the job before.
Don’t expect economic growth or increased taxes to fix this problem, and don’t expect politicians to get tough with unions representing government workers. When the cash runs out, the pension checks still go out. It’s the bondholders who get stiffed.
The next hazard for muni bond owners is inflation. It takes a real act of faith to believe that the fiscal and monetary actions taken to stem the financial crisis will not lead to high inflation.
Washington has taken notice of the budget problems at the municipal and state levels. Aside from bailing states out of their deficits with donations to their operating accounts, federal politicians included in the economic stimulus package a subsidy of municipal financing for capital projects via Build America Bonds. This program creates a new kind of taxable municipal bond that comes in two forms. Tax Credit Build America Bonds pay bondholders taxable interest income but provide them with a tax credit equal to 35% of the interest received. The more popular alternative to these bonds among municipalities are Direct Payment Build America Bonds. For these bonds the Treasury provides the issuing municipality a 35% subsidy when each interest payment comes due. The bondholder in this case receives no tax deduction or credit, only a higher interest rate. These bonds are hugely popular with municipalities, so expect them to become a permanent federal program. They also have a ready market among corporate bond buyers who are suffering from a lack of new issues. Be careful when buying any of these bonds. You need to know which type of bond you are being offered, since the difference in interest yield will be significant.
Moody’s ( MCO ) says it’s changing the rating scale for some 70,000 municipal bonds to bring them in line with sovereign and corporate ratings. This may result in a short-term uptick in prices for the muni market, but the timing couldn’t be worse. I still don’t want to own these bonds.
If you must put some money in municipal bonds, look for insured bonds that got downgraded when the insurers got downgraded. The insurance may no longer be worth much, but the vetting by the insurance companies–which were pretty cautious about the borrowers they could trust–is still worth something.