The Imminent Collapse of Municipal Bonds

Why aren’t more municipal bonds being downgraded by the ratings agencies Fitch, Moody’s and S&P? If you look at sovereign debt in revenue-constrained countries like Greece, Portugal or Ireland, the ratings agencies are issuing warnings.

But, states and municipalities are suffering from the same revenue constraints. Tax revenues have plunged. Governments have shut down services to save cash. And they have cut staff. There are dozens of articles in the national press daily detailing the difficulties municipalities, cities and states are having.

You wouldn’t know that if you looked at the charts of some of the major municipal bond funds. Take a look at Nuveen Municipal Value Fund (NUV) for example. It bottomed in December last year. Now, 11 months later it is up 31%. How about BlackRock’s MuniHoldings Insured Investment Fund (MFL). It bottomed in December as well. But is up over 70% since then. Pretty nice return. But, I don’t think it can last.

California’s summer struggles made it is the poster child of the distress in the finances of US states and municipalities. But, there are many states, cities and municipalities on the brink. That’s why I found the excerpt from the post “The Coming Collapse of the Municipal Bond Market” at Phillip Greenspun’s blog over at Harvard Law School interesting. Note the highlighted sections

A money manager friend showed me an interesting research report by Frederick J. Sheehan titled “Dark Vision: The Coming Collapse of the Municipal Bond Market. This is a product of weedenco.com and available only to subscribers, but I will summarize it here.

Sheehan starts off by noting that a lack of panic by the ratings and government agencies does not indicate health for a financial market. He cites the fact that the Fed did not anticipate how bad the subprime collapse was likely to be and obviously the Moody’s and Standard and Poor’s ratings were ridiculous.

Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker.

Municipalities dealt with the separation between taxes and expenses by borrowing. In the mid-1990s, states and cities were retiring as much debt as they were incurring. During the 2000s, though, they borrowed about $150 billion per year in aggregate, peaking at $215 billion in 2007 by which time $2.7 trillion in debt was outstanding, more than two years’ worth of tax receipts.

Barring some sort of miraculous boom in the economy and pension fund investment returns, state and local governments are headed for insolvency and default. This means that valuing a municipal bond becomes a matter for a legal expert rather than an accountant. Even for the legal expert, it is apparently tough to predict what will happen. Let’s start with the Wikipedia article on Chapter 9 bankruptcy: “Previous to the creation of Chapter 9 bankruptcy the only remedy when a municipality was unable to pay its creditors was for the creditors to pursue an action of mandamus, and compel the municipality to raise taxes. During the Great Depression this approach proved impossible so in 1934 the Bankruptcy Act was amended to extend to municipalities.”

Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens.

Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash.

Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds).

Municipal bonds are still perceived as almost risk-free by most investors and consequently offer a low yield, according to Sheehan. He points out that if the municipalities don’t default, the investor gets only a slightly better return than in Treasuries. Why take the risk if you’re not getting paid for it?

This ends my summary of Sheehan’s report. My own opinion is that the main lesson of subprime is that an investor cannot rely on the ratings agencies or the government to protect his or her interests. The never-employed guy in Cleveland with the house in a crummy neighborhood and no down payment? The risk that he would never make a payment should have been apparent to any investor who dug underneath the asset-backed security. Similarly, an investor in muni bonds can look at the municipality. Does the state have a shrinking population, high public employee salaries, and a big pension obligation overhang from when the population was larger? They probably will eventually default. And if an insurance company was dumb enough to insure the bonds, they’ll probably be bankrupt too.

If you’re waiting until the ratings agencies give you a heads up, thinking this will happen before these problems get reflected in lower muni bond prices, you better think again.

Comments

[Leftfield:]

Great points, that a legal expert is possibly more necessary than an accountant to assess state/local bonds. The short history of municipal bankruptcy and how the question of whether bondholders or pensions are senior is unresolved. And, whether municipalities can go bankrupt and accept a tap on the wrist of higher future interest rates, or lose property.
Very illuminating also is that state/local employment has gone from 5 million to 20 million since 1955. And they receive 43% higher pay than private sector workers. I'm sure that was the reverse in 1955 and that lush public benefits are understated in the calculation. Clearly, since state/local taxes must have risen 4-fold in that time, at least, levied on a poorer private sector (those taxes are generally regressive), the burden Americans carry for government is staggering. No wonder, with all those extra laws, steps, procedures and cost, the private sector is staggering.

Nov 05 07:31 AM

[Sterling Ha...:]

One interesting factor is that while municipalities can go bankrupt, states can't. Major tax increases in the biggest spending states look extremely likely in the near future.

Nov 05 08:12 AM

[Michael Clark:]

Great article. This is one of the reasons we are clearly not at the bottom of the crisis yet. There is SO MUCH complacency in the market at the moment. When one considers all the black clouds on the horizon (Fed policy/dollar death scenario - commodity price appreciation scenario; mortgage resets; mortgage defaults continuing to rise; commercial real estate melting down; local and state governments becoming insolvent; S&P future valuation at PE 145) -- this is not a 'wall of worry', this is a 'wall of water' approaching with Tsunami-like power and speed -- one has to wonder why there is so much blithe self-satisfaction among so many investors. "We survived another crisis, oh well." But these crises are likely to come wave after wave.

The Municipal Bond appreciation reminds me of the Spanish Index appreciation. Who in their right mind invests in an entity that is already dead, bloating, and beginning to smell? Take a look at the chart of SMSI, the Madrid Index.

I guess a rising tide lifts ALL boats. And Mister Bernanke has been trying to convince the world that this rising tide will never recede, as long as he is managing the dike. Once the dam breaks, however, all this complacency is going to seem like a toxic potion of self-delusion. The tide doesn't rise for ever, even if the Inflationists' creed claims it does. And the Wall of Worry will soon be transformed into a wall of shame -- again. This time we will have to take away the punch bowl and shut down Party Town at the Federal Reserve. And I guess we'll have to revoke Mister Bernanke's title (and Nobel Prize) as 'Savior of the World' -- and he'll have to go to work for Goldman Sachs.

Nov 05 08:13 AM

[Roger Knights:]

"There is SO MUCH complacency in the market at the moment. When one considers all the black clouds on the horizon ... this is not a 'wall of worry', this is a 'wall of water' approaching with Tsunami-like power and speed -- one has to wonder why there is so much blithe self-satisfaction among so many investors. "We survived another crisis, oh well." But these crises are likely to come wave after wave."

The Powers That Be--i.e., the Pranksters Above--have a motto: "Let's see fool them again." First (in 2008) they fooled the bulls, then (in March) they fooled the bears, now it's the bulls turn again.

Nov 05 08:30 AM

[GlobalTrekker:]

I guess I am starting to become the contrarian voice in the never ending tirades against public institutions and their funding. But I believe the intellectual thrust of this article is a tad facile, preaching to the choir, as it were, and ignores some distinct features of the municipal bond market. Municipal markets may not be able to print money, but they have many tools at their disposal to satisfy bond holders.

Interest payments are usually very senior in the states' hierarchy, and revenue bonds continue to collect tolls, fuel taxes, and utility surcharges. These have fallen little. CA and others have risen the sales tax 1%, and that's a lot of money in the world's 8th largest economy.

Many states actually are cutting back services, so much of what the old saws say in this article is untrue.

Also, comparing expenses in 1955 versus nearly 2010 is really quite a mental stretch. This is not the same nation as 55 years ago, despite what perhaps many readers might wish.

It's always a little surprising to me that people claim to be so patriotic but deride all those who work for the nation. Do you really have so little regard for the value and services of our nation's military, teachers, forest fire fighters, meat inspectors, police, firemen, park rangers, state university professors, flight controllers?

Factually, the article also falls a bit short: "the investor gets only a slightly better return than in Treasuries." Uhm, on what planet have you been residing? My Vanguard muni funds have been yielding 4.3%, a double-tax-free equivalence of nearly 8%, not counting the huge appreciation I've enjoyed. The triple-A rating may be suspect, but I'll take my chances. In the CEF muni world I have funds paying out over 10% in tax equivalent yields, again, ignoring the far larger appreciation received since purchase in the spring.

In all, the muni market is in trouble, like most of the economy, but the writers protest too much. The states comprise America, and America is filled with potential, creativity, and vigor -- throughout, not just in a few Silicon Valley start-ups.

Nov 05 08:33 AM

[MarkitWacha:]

Return OF Investment is more important than Return ON Investment.

Regarding the revenue bonds, yes, they're more stable. Regarding bonds in general, can I get a loan from you at 8%, please? I'll sell you a bond backed by my income at that if I could. Here's why: In an environment of rising interest rates, higher vol (beta), and higher general risk, an 8% return is folly. 20% is reasonable. People accepted 8% only because of the temporary depreciation phase we've gone through, thanks to the Fed (but it could have been worse). I suspect a lot of people were accustomed to a fat check from their investment account, and reallocated to munis for a quick buck (like Buffett). The time is coming for the inflationary phase, though, as all the bad loans specific to this country make this country's currency worth less relatively than others. Inflation won't be driven by salaries, but by prices on goods and commodities.

As an engineer, I see creativity every day. The breakthroughs that make a huge difference aren't ready for another 5 years, and they need a stable environment to appear. I don't think markets will be stable in 5 years, and that's the challenge.

On Nov 05 08:33 AM GlobalTrekker wrote:

> I guess I am starting to become the contrarian voice in the never
> ending tirades against public institutions and their funding. But
> I believe the intellectual thrust of this article is a tad facile,
> preaching to the choir, as it were, and ignores some distinct features
> of the municipal bond market. Municipal markets may not be able
> to print money, but they have many tools at their disposal to satisfy
> bond holders. Interest payments are usually very senior in the states'
> hierarchy, and revenue bonds continue to collect tolls, fuel taxes,
> and utility surcharges. These have fallen little. CA and others
> have risen the sales tax 1%, and that's a lot of money in the world's
> 8th largest economy. Many states actually are cutting back services,
> so what of the old saws in this article is untrue. Also, comparing
> expenses in 1955 versus nearly 2010 is really quite a mental stretch.
> This is not the same nation as 55 years ago, despite what perhaps
> many readers might wish. It's always a little surprising to me that
> people claim to be so patriotic but deride all those who work for
> the nation. Do you really have so little regard for the value and
> services of our nation's military, teachers, forest fire fighters,
> meat inspectors, police, firemen, park rangers, state university
> professors, flight controllers? Factually, the article also falls
> a bit short: "the investor gets only a slightly better return than
> in Treasuries." Uhm, on what planet have you been residing? My
> Vanguard muni funds have been yielding 4.3%, a double-tax-free equivalence
> of nearly 8%, not counting the huge appreciation I've enjoyed. The
> triple-A rating may be suspect, but I'll take my chances. In the
> CEF muni world I have funds paying out over 10% in tax equivalent
> yields, again, ignoring the far larger appreciation received since
> purchase in the spring. In all, the muni market is in trouble, like
> most of the economy, but the writers protest too much. The states
> comprise America, and America is filled with potential, creativity,
> and vigor -- throughout, not just in a few Silicon Valley start-ups.

Nov 05 08:58 AM

[Edward Harr...:]

You make some fair points. Obviously, one reason Munis are attractive has to do with the tax free status for many investors and that gives it a yield pickup over Treasuries.

The question you ask which is most interesting has to do with the seniority of the bonds and the security of the income stream to investors. general obligation bonds are obviously of more dubious security than bonds funded by specific income streams. I would expect there to be a dichotomy in performance based on this factor.


On Nov 05 08:33 AM GlobalTrekker wrote:

> I guess I am starting to become the contrarian voice in the never
> ending tirades against public institutions and their funding. But
> I believe the intellectual thrust of this article is a tad facile,
> preaching to the choir, as it were, and ignores some distinct features
> of the municipal bond market. Municipal markets may not be able
> to print money, but they have many tools at their disposal to satisfy
> bond holders.
>
> Interest payments are usually very senior in the states' hierarchy,
> and revenue bonds continue to collect tolls, fuel taxes, and utility
> surcharges. These have fallen little. CA and others have risen
> the sales tax 1%, and that's a lot of money in the world's 8th largest
> economy.
>
> Many states actually are cutting back services, so much of what the
> old saws say in this article is untrue.
>
> Also, comparing expenses in 1955 versus nearly 2010 is really quite
> a mental stretch. This is not the same nation as 55 years ago, despite
> what perhaps many readers might wish.
>
> It's always a little surprising to me that people claim to be so
> patriotic but deride all those who work for the nation. Do you really
> have so little regard for the value and services of our nation's
> military, teachers, forest fire fighters, meat inspectors, police,
> firemen, park rangers, state university professors, flight controllers?
>
>
> Factually, the article also falls a bit short: "the investor gets
> only a slightly better return than in Treasuries." Uhm, on what
> planet have you been residing? My Vanguard muni funds have been
> yielding 4.3%, a double-tax-free equivalence of nearly 8%, not counting
> the huge appreciation I've enjoyed. The triple-A rating may be suspect,
> but I'll take my chances. In the CEF muni world I have funds paying
> out over 10% in tax equivalent yields, again, ignoring the far larger
> appreciation received since purchase in the spring.
>
> In all, the muni market is in trouble, like most of the economy,
> but the writers protest too much. The states comprise America, and
> America is filled with potential, creativity, and vigor -- throughout,
> not just in a few Silicon Valley start-ups.

Nov 05 10:03 AM

[Old Trader:]

"Why aren’t more municipal bonds being downgraded by the ratings agencies Fitch, Moody’s and S&P? If you look at sovereign debt in revenue-constrained countries like Greece, Portugal or Ireland, the ratings agencies are issuing warnings."

Just a thought, because munis are defintely not my area of expertise, but could it be that there's a perception of some sort of Federal backstop if things got REALLY ugly, while there's nothing to backstop a sovereign default?

Nov 05 10:14 AM

[Choad Mangler:]

I read the Dark Vision report and it is a scare piece with little substantive information to support his theory that we are headed for some sort of collapse in municipall finance - in fact, it borders on silly. Pensions obligations can, and will be, rejected and renegotiated as needed. Municipal debt, specifically the bonds in your portfolio, are real debts under chapter 9 of the bankruptcy code and while they can be readjusted, they cannot be wiped away. Without going into too much detail, because I dont have the time today, the prerequisites for a municipal bankruptcy are extremely difficult to meet, and they is indeed a longer history of municipal bankruptcy than you might think - with recovery rates on defaulted munis very close to par on average. Look, engage in solid due diligence, build a diversified portfolio of credits, and you're going to do just fine - particularly when the new tax regime kicks into place in 2011.

Nov 05 10:40 AM

[Old Trader:]

" Municipal debt, specifically the bonds in your portfolio, are real debts under chapter 9 of the bankruptcy code and while they can be readjusted, they cannot be wiped away. "

Perhaps, but it might be wise to recall what happened to GM's bondholders. TPTB seem to have no issue with re-writing contract law as they see fit.

Nov 05 11:23 AM

[Angel Martin:]

I don't trust the ratings agencies, and individual opinions are a dime a dozen.

Are CDS spreads increasing for municipals?

Nov 05 12:07 PM

[chris coonan:]

and the State of California is taking no interest loans from taxpayers paychecks now, without notice....so if the voters are not sacred, neither are the bond holders

Nov 05 12:36 PM

[Choad Mangler:]

"Perhaps, but it might be wise to recall what happened to GM's bondholders. TPTB seem to have no issue with re-writing contract law as they see fit."

I certainly don't agree with how the GM case was handled, but how does that have anything to do with municipal finance? Section 363, which dictated the sale of Old GM's assets to New GM, relates to Chapter 11 of the Bankruptcy Code. There is no such provision in Chapter 9. Besides, since the federal government was GM's largest creditor, they technically had the right to make this decision, while the 10th amendment specifically protects the rights of states to administer their municipalities as they see fit. The federal government cannot interfere, and for that matter, the role of the bankruptcy judge is actually quite limited. So I don't see how the GM comment has any relevance to this conversation.

Nov 05 02:44 PM

[Choad Mangler:]

Not really. But I always find it interesting when people bring up CDS spreads. You understand that a credit default swap contract involves you and a counterparty, so with that said - wouldn't you be more concerned about the counterparty's ability to satisfy his side of the swap if, for example, the State of Georgia was defaulting on its debt and triggering payment on the swap? It just makes no sense to me that you can have a referenced entity with less credit risk than the other side of your swap, such as Lehman, Bear or AIG. Maybe the move towards exchanges helps alleviate that a bit, but I still question the validity and usefulness of municipal CDS for investors - even to hedge a large book of bonds.

On Nov 05 12:07 PM Angel Martin wrote:

> I don't trust the ratings agencies, and individual opinions are a
> dime a dozen.
>
> Are CDS spreads increasing for municipals?

Nov 05 02:55 PM

[Old Trader:]

choad,

While certainly not a lawyer, I understand that municpal debt falls into a different category. The point that I'm trying to make, is that given how the GM situation was handled, I wouldn't rest easy with an investment in muni debt solely on the grounds that "the code won't allow it", in terms of the safety allegedly provided by contract law.


On Nov 05 02:44 PM Choad Mangler wrote:

> "Perhaps, but it might be wise to recall what happened to GM's bondholders.
> TPTB seem to have no issue with re-writing contract law as they see
> fit."
>
> I certainly don't agree with how the GM case was handled, but how
> does that have anything to do with municipal finance? Section 363,
> which dictated the sale of Old GM's assets to New GM, relates to
> Chapter 11 of the Bankruptcy Code. There is no such provision in
> Chapter 9. Besides, since the federal government was GM's largest
> creditor, they technically had the right to make this decision, while
> the 10th amendment specifically protects the rights of states to
> administer their municipalities as they see fit. The federal government
> cannot interfere, and for that matter, the role of the bankruptcy
> judge is actually quite limited. So I don't see how the GM comment
> has any relevance to this conversation.

Nov 05 04:12 PM

[Choad Mangler:]

If it is contract law you doubt, then I think your problem likely extends well beyond the confines of the municipal bond market. And not to beat a dead horse, but there was no violation of contract law in the GM bankruptcy. It was perfectly legal, if not disingenuous in the way it was implemented.

Nov 05 04:27 PM

[macro -N- i...:]

But that is exactly the point. The problem does extend. When the rule of law becomes flippant in use the foundation and infrastructure of law ends.

Nov 05 06:35 PM

[a fat panda:]

"America is filled with potential, creativity, and vigor -- throughout, not just in a few Silicon Valley start-ups."

I couldn't agree more. The problem is that the government is diverting capital away from creativity and potential to prop-up the past. The real problem with the TARP isn't that we are bailing out the foolish. It is that it deprives real businesses the capital that they need to ride out this storm.

The capital that we put into banks, home builders, and autos comes from somewhere. Whether it is taxes or inflation, TARP is pushing capital from one person to someone else via government fiat. That capital comes from somewhere.

It isn't just the capital from the government. Once the government puts money into Citi, private citizens like me are more willing to lend to them. Have you seen what has happened to Citi debt over the last year? It isn't just the TARP that goes into the abyss of capitalism. The TARP is propping up the weak, and the weak have become a blackhole sucking capital from the rest of the economy.

Look at what Citi - a virtually bankrupt company - can borrow at and try and get those terms for a new business or even a fresh look at an old business. This is acknowledge by Buffett in his last annual report when he said that bankrupt companies could borrow for much less than well run businesses.


On Nov 05 08:33 AM GlobalTrekker wrote:

> I guess I am starting to become the contrarian voice in the never
> ending tirades against public institutions and their funding. But
> I believe the intellectual thrust of this article is a tad facile,
> preaching to the choir, as it were, and ignores some distinct features
> of the municipal bond market. Municipal markets may not be able to
> print money, but they have many tools at their disposal to satisfy
> bond holders.
>
> Interest payments are usually very senior in the states' hierarchy,
> and revenue bonds continue to collect tolls, fuel taxes, and utility
> surcharges. These have fallen little. CA and others have risen the
> sales tax 1%, and that's a lot of money in the world's 8th largest
> economy.
>
> Many states actually are cutting back services, so much of what the
> old saws say in this article is untrue.
>
> Also, comparing expenses in 1955 versus nearly 2010 is really quite
> a mental stretch. This is not the same nation as 55 years ago, despite
> what perhaps many readers might wish.
>
> It's always a little surprising to me that people claim to be so
> patriotic but deride all those who work for the nation. Do you really
> have so little regard for the value and services of our nation's
> military, teachers, forest fire fighters, meat inspectors, police,
> firemen, park rangers, state university professors, flight controllers?
>
>
> Factually, the article also falls a bit short: "the investor gets
> only a slightly better return than in Treasuries." Uhm, on what planet
> have you been residing? My Vanguard muni funds have been yielding
> 4.3%, a double-tax-free equivalence of nearly 8%, not counting the
> huge appreciation I've enjoyed. The triple-A rating may be suspect,
> but I'll take my chances. In the CEF muni world I have funds paying
> out over 10% in tax equivalent yields, again, ignoring the far larger
> appreciation received since purchase in the spring.
>
> In all, the muni market is in trouble, like most of the economy,
> but the writers protest too much. The states comprise America, and
> America is filled with potential, creativity, and vigor -- throughout,
> not just in a few Silicon Valley start-ups.

Nov 06 10:35 AM

[American in...:]

It is not a great article. It is a terrible article. Municipalities have enjoyed much lower default rates than corporate bonds.

There is no evidence of a massive wave of muncipal defaults pending.

The author doesn't cite a single relevant fact such as the size of budget deficit. Instead he talks about long term trends such as compensation per employee. Frankly speaking, compensation per employee tells me little about the balance sheet and cash flows of a municipal entity (a city, a hospital, a state, etc.).

And what is this nonsense about low yields. The US faces zero inflation and you can buy the Vanguard High Yield fund, which is yielding over 4% tax free or the Van Eck High Yield municipal bond fund, which is yielding 6.5%. The tax equivalent yield of the latter for those in the 35% bracket is nearly 10%.

Long on irrelevant details, short on cogent argument.

On Nov 05 08:13 AM Michael Clark wrote:

> Great article. This is one of the reasons we are clearly not at
> the bottom of the crisis yet. There is SO MUCH complacency in the
> market at the moment. When one considers all the black clouds on
> the horizon (Fed policy/dollar death scenario - commodity price appreciation
> scenario; mortgage resets; mortgage defaults continuing to rise;
> commercial real estate melting down; local and state governments
> becoming insolvent; S&P future valuation at PE 145) -- this is
> not a 'wall of worry', this is a 'wall of water' approaching with
> Tsunami-like power and speed -- one has to wonder why there is so
> much blithe self-satisfaction among so many investors. "We survived
> another crisis, oh well." But these crises are likely to come wave
> after wave.
>
> The Municipal Bond appreciation reminds me of the Spanish Index appreciation.
> Who in their right mind invests in an entity that is already dead,
> bloating, and beginning to smell? Take a look at the chart of SMSI,
> the Madrid Index.
>
> I guess a rising tide lifts ALL boats. And Mister Bernanke has been
> trying to convince the world that this rising tide will never recede,
> as long as he is managing the dike. Once the dam breaks, however,
> all this complacency is going to seem like a toxic potion of self-delusion.
> The tide doesn't rise for ever, even if the Inflationists' creed
> claims it does. And the Wall of Worry will soon be transformed into
> a wall of shame -- again. This time we will have to take away the
> punch bowl and shut down Party Town at the Federal Reserve. And
> I guess we'll have to revoke Mister Bernanke's title (and Nobel Prize)
> as 'Savior of the World' -- and he'll have to go to work for Goldman
> Sachs.

Nov 07 04:00 PM

[cincinnatijake:]

The appetite for munis has begun to wane, giving impetus to the marketing of BABs (Build America Bonds). These bonds are taxable, but offer a higher yield than tax-exempt municipals. In addition, the government will foot the bill for 35% of the interest charge. In a fascinating article by Andrew Edwards of the WSJ, Edwards found “if a public university sells BABs with an interest rate of 5%, the university ends-up paying only 3.25%, with Uncle Sam’s subsidy effectively picking up the difference.”
“Investors Push to Extend BABs: Proponents Say Build America Bonds Have Done Well” online.wsj.com/article...

Essentially, the investor indirectly pays the tax by giving it to Uncle Sam to give to the broke municipalities, in the meantime rapidly increasing the government’s liability in interest payments. Why not just ask taxpayers for direct donations to pay down the deficit? Oh, that’s right…they have already tried that and according to a CNN poll 85% Americans thought the government was joking. It looks like the U.S. risk-free investments ain’t so risk free anymore and one has to seriously ponder if a serious increase in the U.S. sovereignty risk is in order.

Nov 19 08:28 PM