The Municipal Bond Crisis Is About to Begin

by: Graham Summers

Thus ends one more safe haven.

For decades municipal bonds have been considered one of the safest income plays on the planet. If you’re unfamiliar with these investments, municipal bonds or muni bonds as they’re commonly called, are bonds issued by lower tier governments (state, city, or even county) to raise capital for public projects like building a highway, sewer, or what have you.

These bonds are not backed by the Federal government (with its printing presses). Because of this, muni bond interest payments (the yield) are usually tax-free (meaning no Federal or State income tax) in order to attract investors. They also typically yield much more than Treasuries (debt backed by the US Federal Government) due to the perceived increase in risk (again, there is no printing press behind these bonds, so there is no “guarantee” against default).

Historically, muni bonds have been an extremely safe source of income for investors. Between 1970 and 2000, the default rate for all muni bonds was only 0.04%. In contrast, the default rate on corporate bonds (bonds issued by corporations) was 9.8% during the same period.

Thus, historically muni bonds were considered an extremely safe means of securing a massive tax-free yield. Regrettably that “extremely safe” status is now being challenged by the massive deficit problems of state governments.

Many commentators like to point out that the US government has a debt problem. But this issue extends WAY beyond the Federal Government.

Many US states are running major deficits this year. California is the most glaring example, but all in all the US now has 48 states facing deficits ranging from 15% (Arizona) to 0.6% (Florida). In nominal terms, we’re on pace to see $178 billion in state deficits: an amount equal to 26% of total state budgets.

The picture doesn’t get prettier in the future either. When you add in 2011, you’re looking at a total $350 billion in deficits for the two years (2010-2011). And that’s assuming unemployment and other economic issues don’t worsen from here (meaning tax revenues don’t continue to fall).

The only problem is they are.

As of last week, the US Treasury’s “withheld income and employment taxes” is down some $48+ (roughly 7%) billion from last year. Similarly, non-adjusted jobless claims continue to rise: a whopping 500,000+ for the first week of February 2010.

The logic here is quite simple:

Lower wages + higher unemployment= lower tax revenues.

Lower tax revenues + greater government spending= greater deficits.

Greater deficits eventually = insolvency or default.

Which brings us to today. The city of Vallejo, CA declared bankruptcy back in May 2008. Now we see Harrisburg, Pennsylvania passing a 2010 budget which doesn’t include debt payments (as in payments on Muni bonds and other debts the city owes) which is essentially a default.

We’re only just getting started here. I’ve said several times that bonds, not stocks, would be the big story of 2010. That includes muni bonds which are a $3 trillion market. With tax revenues falling and major debt issues to consider we are going to be seeing a heck of a lot more defaults and bankruptcies coming from local, city, and state governments.

But what about a Federal bailout from Uncle Sam?

Obama already threw $140 billion towards helping state deficits over a 2.5 year period. But remember, states are facing $350 billion in deficits. So the Federal Government could DOUBLE its handouts and states would STILL be underwater.

Given the increased outcry against additional bailouts / stimulus (see the Massachusetts election), the likelihood of another massive stimulus plan to help states is small. Regardless, if the Federal government did start issuing handouts to states, it would require another $160 billion in cash just to meet demands for the next two years assuming no increase in unemployment or decrease in tax revenues.

Good luck with that.

The fact of the matter is that we are on the verge of a muni bond crisis. The issues plaguing Greece and other eurozone countries are taking place in our own backyard just on a smaller level (for now). Muni bonds were often thought to be a safe haven, but given the economic outlook in the US, that may no longer hold true.

If you hold any muni bonds in your portfolio, I strongly urge you to examine the backing governments’ finances. A little preparation can go a long way towards avoiding major losses especially if you’re counting on those income payments for retirement.

Disclosure: No positions