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As long as the feds and the states were able to prop up the various municipalities with taxpayer funds from another state, munis looked pretty good. But now too many of the states themselves are in deep kimchi. Just one anecdote from my personal geographic vantage point: typically, the time between fall color and open ski resorts up here on the Nevada side of Lake Tahoe is a time we don’t see many out-of-state license plates. In those other times visitors come up, spend money, and leave. Not this year.

This year, however, we see scores of California license plates – most of them parked in front of real estate brokerage offices. California and Nevada are both losing residents: Nevada is losing the hard-core addict gamblers in Vegas who are returning to California’s more generous welfare payouts, and California is losing many of its most productive, entrepreneurial and prosperous citizens to Nevada’s more libertarian tax code. I think we Nevadans are getting the better part of this bargain.

Municipalities in every state derive a healthy portion of their revenue from state subsidies. That’s only fair, since the state sales taxes are collected without regard to which city or county it comes from, but it is the “City of Wherever” or “County of Whatever” that must provide fire, rescue, police and other essential services. However, with many of its most well-off citizens fleeing the onerous taxes and experimental politics of states like California, the income tax base, state sales tax base, and licensing and fees base are all shrinking. At least 45 states are showing declines in total tax revenues.

So what are most of these states doing to replace tax revenue? Creating jobs? Slashing taxes to encourage new businesses? Cutting spending? Of course not. By and large they are raising taxes, getting more and more from fewer and fewer. And the fewer and fewer are voting with their feet. When last I inquired at U-Haul, just to get a feeling for how many people are going which way, I discovered that the cost of a one-way rental from Austin, Texas to San Francisco, California is $900. From San Francisco to Austin, the cost is $3,000. Think that gives a pretty good idea of where all the trailers and trucks are ending up?

Capital goes where it is welcomed and well-treated. Once upon a time that may have been California, Michigan, Illinois, New York, New Jersey or Pennsylvania where, once upon a time, so many Fortune 500 companies were based. Today? It’s Texas that is home to 58 Fortune 500 companies, more than any other state. If you own bonds issued by municipalities in high-tax states, remember: capital goes where it is welcomed and well-treated. People and companies are free to vote with their feet in this country.

The Rockefeller Institute for Government and the Brookings Institution recently estimated that the funding shortfall in state and local governments will exceed $50 billion in 2011. The states with the highest taxes also have some of the worst budget problems – no shock to anyone who understands the difference between individual entrepreneurialism and state-sponsored nanny-ism as practiced in high-tax, high-nanny-factor California, Michigan, , Illinois, New York, New Jersey and Pennsylvania. All of these states are slashing revenue-sharing with their local governments.

The markets will recover. The economy will recover. But vast sectors of the economy will not – or they will lag significantly, during which time your money invested there will either be dead money or dying money.

What to do now? That is an individual decision. For me -- I have sold off all of my and our clients’ once-substantial holdings of the munis we purchased for them a couple years back when bonds really were a safe haven against the vagaries of the equity markets.

If you insist upon holding munis, I suggest you ONLY own investment grade bonds (AAA, AA, A or, only for the gamblers out there, BBB.) Also, research on your own or ask your broker what kind of cash reserves the issuer of your bonds maintains. Anything less than 18 months to two years...sell the bond while you can. In addition, accept a little less interest but buy “pre-refunded” or “escrowed to maturity” bonds. You’ll earn less with this money-in-the-bank-to-pay-at maturity kind of bond, but you should be every bit as concerned this year about the return of your principal, not just the return on your principal.

I think a shakeout is coming for all bond classes (except for “floating rate bonds” that re-set and rise with increases in inflation.) I wouldn’t touch most with a 10-foot pole. Not when I can buy the stocks of quality firms that pay current dividends higher than bonds pay today, which also have a history and likely a future of increasing those dividends!

For munis, these days, I’d paraphrase Chief Martin Brody (the Roy Scheider character) in Jaws: “We’re gonna need a longer pole…”

Author's Disclosure: As of today, we are completely out of all muni bonds. Sometimes advising what and when to sell is more valuable than discussing what and when to buy…

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Source: Munis: Poised on a Knife's Edge