How safe are municipal bonds? The correct answer is that it
depends on who you ask.
Politicians say munibonds are still a good bet. Credit raters
say that a AAA-rated bond is safer than a B- rated bond and actual
credit risk is relative. Financial intermediaries (salespeople)
promote munibonds (Nasdaq: FHIGX) for their tax free income.
Let's take a quick look at California to see what's really
happening in the $3 trillion munibond market.
Case Study: The Republic of Kalifornia
California is home to 37 million Americans and is a case study in
fiscal insanity. On November 16, 2011, the Office of Legislative
Analyst released a report forecasting a budget deficit of $3
billion at the end of 2011-12 and an operating shortfall of $9.8
billion by 2012-13.
Today, California's actual budget deficit is now a $16 billion
headache (up from $9 billion in January).
Instead of tackling debt, California lawmakers approved a $68
billion project to build a high-speed train connecting Los Angeles
and San Francisco. (A flight from L.A. to S.F. takes about one hour
and costs around $100 one way vs. a 10 hour drive.) Interestingly,
the approval allowed the state to collect $3.2 billion in federal
funding that would've otherwise been rescinded. The federal
government rewarded California for needless spending projects,
leaving U.S. taxpayers on the hook!
Like many states, California is burdened by falling tax revenue,
a $3.6 billion unfunded liability (per capita) for retirement
benefits and rising Medicaid costs.
Lack of employment is something California and Spain both share in
common. According to Department of Labor Department
figures, California's average unemployment rate from July 2011
through June 2012 was 11.2%. But its broader "under-employment"
rate was an elevated 20.3%. Translation: Income tax
revenue cannot increase with an employment market this weak.
To solve its financial problems, Gov. Jerry Brown (
D
) wants California voters to approve "temporary" tax increases on
the highest income earners along with the sales and use tax rate by
0.5%. The vote is set for November 2012. Will other states copy
California by trying to coax taxpayers into paying higher
taxes?
California may be an extreme example of the fiscal challenges
facing states, but it's still a good representation of big problems
elsewhere.
Broke Cities
The bankrupt city of San Bernardino offers munibond investors
another look - a more localized snapshot of financial
incompetence.
Because of accounting mistakes, city officials believed they had
more money than was actually on hand. In fiscal year 2010-11, they
mis-reported a balance of $1.7 million, when it was actually just
$410,293. And the following fiscal year, the reported balance was
$2 million, when it was really minus $1.18 million.
Despite these serious flaws, politicians and credit analysts
continue to laud munibonds for their "historically low default
rates." And like sacrificial lambs, the dumb money is listening.
Asset flows into munibond mutual funds through the first six months
of 2012 is on pace to match or surpass the record years of
2009-10.
Highly populated cities with large deficits like Cincinnati,
Detroit, and Los Angeles look poised to follow San Bernardino's
lead to financial oblivion.
The Opportunity of Opportunities
For now, the municipal bond market (NYSEArca: MUB) has been a calm
place to invest. State specific funds linked to California
(NYSEArca: CMF), New York (NYSEArca: NYF) and others have marched
ahead. Money market munibond funds (Nasdaq: FTEXX) have held
steady. And unsuspecting investors continue to pile in.
But state tax revenues, based upon history, (see chart below) have
been volatile and are entering a new phase of even higher
volatility. Unlike the U.S. government, they can't print their way
out of debt. The stars are aligning.
For traders, abreak below support for munibond
ETFs
will signal a high probability setup for shorting. Being too late,
will mean a missed opportunity and being too early will mean
disappointment.
The
August ETF Profit Strategy Newsletter
identifies mega-investment themes by using sentiment, cash flow,
and other key indicators to locate trading opportunities ripe for
the plucking.
