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
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
• Underfunded Retirement Promises Create Risks for Future
• 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
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.
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 (
) 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