Municipal Bonds: On Shaky Ground

by: Brian Rezny

Illinois: the Land of Lincoln. On December 3, 1818 Illinois became the 21st state admitted into the union. And today, it is the state most likely to default on its debt. How bad is it? Illinois scores just above Dubai on likelihood of default, according to CMA. And that’s nothing for the prairie state to be proud of.

click to enlarge images

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Yes, Illinois is the worst, and California is right on its heels. But the reality is that the trouble in the municipal bond market spreads well beyond these two hardship cases. So far this year, rating agencies have downgraded seven municipalities. And even worse: of the near record $500 billion in municipal debt issued last year, just under 9% was insured (according to Forbes).

But that hasn’t stopped investors from swarming to municipal debt. Yields on municipal bonds are down (because investors are buying them and driving up prices). And who’s buying? First and foremost, American households. They hold $1 trillion of the $2.8 trillion municipal bond market.

Here is an overview of municipal debt holders, according to the Federal Reserve Flow of Funds report for the first quarter of this year:

  • Households: $1 trillion
  • Mutual funds: $500 billion
  • Insurance companies: $372 billion
  • Money market mutual funds: $368 billion
  • Commercial banks: $220 billion

But here’s the thing: as Kevin Depew of Minyanville points out, households actually hold much more than $1 trillion in municipal bonds, because they indirectly hold the debt attributed to mutual funds and insurance companies. Bottom line: we have a lot of exposure to the municipal bond market. And that translates to: we have a lot of exposure to the regional problems of debt-burdened municipalities.

And while yields on municipal bonds are falling, credit default swaps are rising. That means that while we are funneling money into municipal debt, the cost to insure that debt against default is rising (as measured by the Markit MCDX index). And that doesn’t add up.

Granted, historically the default rate on municipal debt is less than .5% in a five year period, according to Moody’s. But the past is the past. In 2009, 183 issuers defaulted on $6.4 billion in debt, according to the Distressed Debt Securities Newsletter. And today, municipalities are facing more debt burdens (pension funds are a huge liability), and declining tax revenues (down 7% last year according to the Census Bureau).

Warren Buffet recently said that he sees a “terrible problem” developing in the municipal bond market. And according to the Wall Street Journal: “Investors are ignoring warning signs in the $2.8 trillion municipal-bond market, raising the risk of a reckoning”. The bottom line: municipal bonds might look attractive because of their tax-free returns, but that feature won’t matter much in the event of a default.

Disclosure: No positions