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It has been rough sledding in the world of municipal bonds (also known as tax-exempt bonds) for several months. State and local government have been in the news for all the wrong reasons: bankruptcies (Vallejo, CA) and threats of bankruptcies, mushrooming budget deficits, burgeoning debt, sluggish tax revenue growth, falling property tax revenues and various contractual problems with unionized municipal and state workers.

A double whammy for muni bond investors

For investors in muni bonds, it has been a double whammy as fears of municipal deficits have added the specter of default to an already difficult environment of rising interest rates.

At every level, government is spending more, deficits are soaring and vast amounts of new debt are being issued. This heavy issuance of debt has led to fears of higher inflation and also to higher interest rates, as you can see from this chart comparing rates on long-term Treasuries versus long-term muni bonds:

Source: Wall Street Journal

The red line shows 30-year Treasury bonds as they have fluctuated in yield since 2000. The blue line shows an index of 30-year muni bonds over the same time period. This chart illustrates what has happened in the past few months. Muni bond yields soared during the panic of 2008, but then began falling until late last year. Conversely, Treasuries had been rising for some time since the lows reached during the panic. Now, both are moving up and in many cases, tax-exempt muni yields are higher than Treasuries of a similar maturity. And, of course, as yields have gone up, prices for existing bonds have fallen.

Here is a good summary of the situation [emphasis added]:

…Since late August, when Mr. Bernanke foreshadowed the Fed’s second round of bond buying, the yield on 30-year Treasury bonds has increased to nearly 4.6%, a jump of 30%. Over the same period, Municipal Market Data’s AAA-rated 30-year muni benchmark has seen yields surge to 5%, an increase of 36%. That has spelled big losses for investors, since bond prices move in the opposite direction of yields. Long-dated bond prices are particularly sensitive to such moves because investors are locked into the paper for an extended period.

Rising Treasury yields are one response to the Fed’s money printing, which risks inflation and interest-rate increases down the line. Muni yields have risen somewhat faster because worsening state and local budgets also have raised the specter of muni credit risk.

But muni-market bulls focused on refuting Ms. Whitney’s argument about credit risk tend to underplay the big impact of a reflating economy, to say nothing of the end of the Build America Bonds federal subsidy. The bond program helped soak up heavy muni issuance by luring non-tax-exempt investors into the market, who have now left. These last two factors explain much of the increase in yields…

The Perfect Storm

Muni bond investors are wondering what the heck is going on. This relatively placid backwater of bonds is facing a perfect storm of fundamental weakness in municipal and state finance, coupled with an environment in which interest rates are likely to trend upward over time.

My position is that I’m neither a bull nor a bear for muni bonds. As yields go up, good quality munis become more attractive and worthy of consideration. Also, the ending of the Federal subsidy for state-issued Build America Bonds has made them, if anything, more attractive as the supply is limited. On the other hand, states and municipalities need to issue lots of debt and that means the supply of normal tax-exempt municipal bonds (as opposed to taxable Build America Bonds) is likely to go up.

What’s next?

The likelihood of additional Federal subsidies to states and cities is diminishing, and state and local interest costs are clearly going up. In other words, the fundamentals of state and local finance are not getting better anytime soon. In fairness, there have been a few points of light as modest economic improvement has led to a decent increase in some tax revenues. So, all is not bad.

Nonetheless, the trend is not good because few cities and states have realized how difficult their financial affairs have become. And, I fear that some are hoping — in vain I believe — for a Federal bailout.

Disclosure: No positions

Source: Muni Bonds Face a Perfect Storm