Why to Avoid the Municipal Bond Market

 |  Includes: BAB, PRB
by: Roger Nusbaum

John Spence had an article run on Marketwatch over the weekend weighing the pluses and minuses of municipal bonds and municipal bond ETFs. A few days ago, Matt Hougan wrote a favorable piece on the PowerShares Build America Bond ETF (NYSEARCA:BAB) and, over the weekend, the Barron's cover story was about the current state of the states. Mike Shedlock writes prolifically about current economic events in the states. Read all of this, if you haven't already.

The big macro is that many states are in a lot of trouble. Per the Barron's article, called The $2 Trillion Hole, 46 states have underfunded pensions, although I should note that a few of the states are only off by a slight amount. You probably also know that 48 states (South Dakota and Montana were the two exceptions the last time I looked) have budget deficits.

If employment does not improve then the states will collect less in the way of income tax. If home prices continue to go down then the states will collect less in the way of property tax. And if all of this impedes consumer spending (not an unreasonable conclusion), then states will collect less in the way of sales tax. This all serves to seriously threaten the revenue structures of the states.

Then layer on the pension issues and consider that weaker states have to pay more to borrow which only worsens the situation. Regardless of how you think this part of the story will work out, it is clearly a mess right now. About a year ago I mentioned getting out of California munis for any client who had them. A couple of readers left comments sort of disagreeing, in the belief that one way or another things would be OK. I don't buy much in the way of munis but some folks had them from before we managed the accounts.

You may know from past posts that I am not a big fan of taking risk in the fixed income portion of the portfolio and, to the extent we take a little risk, taking risk in treasuries or munis is absolutely not the trade we want to make. I don't want to be the one that has to figure out how this works out with client money on the line. There are plenty of quality corporates that are at a very low risk of failing and quite a few foreign sovereigns at very low risk of failing; lower risk than the states, anyway. With all the stats about the trouble the states are in, if a state does fail how would you, as an advisor, explain to a client why you owned the paper? If they do fail then everyone will say how obvious it was that they were going to fail. I think it makes sense for advisors and do-it-yourselfers to just avoid the space altogether.

If you have to be in the municipal space then maybe the Market Vectors Pre-Refunded ETF (NYSEARCA:PRB) could be a buy, but to be clear we do not own it.

As the Marketwatch article alluded to, investors are seeking yield and so might be willing to take more risk. This may be true, but short term relatively safe paper has a yield in the ones; we are in a 1% world. If you buy a 4% yield you are taking risk and I am quite certain that there are many people, including advisors, who do not fully understand the risk that they are taking.