Municipal bonds have long been a popular investment, as they provide safety from default and tax exempt income. With Treasuries yielding virtually nothing, munis have become an even more popular investment. In 2003, investors chased yield with asset backed securities. While there are still yield chasers, many have replaced Treasury investments with munis expecting similar default risk. Historically, this would be an accurate assessment. Today, however, municipal bonds are beginning to see significant risk. Observe…
Muni Bonds Face Downgrade Risk
Today, many of these issuers are running into financial problems as tax revenues sag because of the weak economy. Morningstar doesn’t expect a dramatic rise in municipal-bond defaults, but argues there could be a significant rise in downgrades. That’s when one or more ratings agencies suggest that a municipal bond is at greater risk of default, even if that risk is still fairly low.
A bond downgrade generally makes a bond less appealing to investors, causing its price to decline. When that happens to enough bonds, the net asset value of a bond fund can fall, offsetting the gains investors get from interest earnings.
Long-term investors learn to live with this kind of jolt. But Morningstar says many muni fund investors, like those who have rushed into other types of bond funds over the past year or so, may be expecting more safety than they will get. Many inexperienced bond investors were fleeing volatility in the stock market, or piling on as they saw healthy gains in munis and other types of bonds.
A wave of downgrades is no longer a risk but a certainty. While the author think default risk is still relatively low, I completely disagree. Many local government are plagued by outrageous union contracts and benefits. These costs are not going away and we’re seeing how politically difficult it can be to actually make cuts. This leaves financing, which has been done for years. Let’s look a this in more depth…
Muni investors still shrug off bad news
“Everywhere you look, someone is saying this is the end of municipal bonds,” said Matt Dalton, chief executive at Belle Haven Investments. “Our customers are unsettled by headline risk, but there still is money coming into this market.”
Total returns in munis — tax-favored debt issued by states and local governments for schools, roads and airports — were just under 11 percent over the last 12 months, including gains of nearly 1 percent during February, according to Bank of America Merrill Lynch indices.
Treasuries, which thrived during 2008’s global credit crisis, have posted total returns of 1.86 percent over the last 12 months, according to the Merrill indices. In February, Treasuries posted total returns of about 0.4 percent.
“It’s almost the reverse of then, when people only wanted to own Treasuries as a safe haven,” said Paul Brennan, a portfolio manager at Nuveen Investments in Chicago. “Now, it is a continuation of what we saw in 2009.”
Badly beaten up in 2008, munis benefited greatly last year as governments stepped up anti-recession spending and investor fears diminished. A year ago, tax-free yields on municipals were eye-popping, sometimes twice that of U.S. Treasuries, when they are normally only two-thirds or a bit better than the taxable payouts on federal debt.
As long as investors refuse to require a premium for obvious risks, municipalities can keep kicking the can down the road. Eventually the economy will sputter and risk awareness will start hitting the investment world again. This author also believes defaults will be low. Again, I disagree. It is no secret how bad the finances at state and local government are these days. This might be concerning in an ordinary recession, however, people are ignoring how entrenched and irreversible these costs are. The city of Vallejo declared bankruptcy in 2008, setting a new precedent for dealing with unmanageable fixed costs. I’d expect many municipalities (in much bigger cities than Vallejo) to follow from this example over the next few years. A string of defaults will undoubtedly cause rates to soar and make funding for other cities that much more difficult. One might argue for state bailouts or bank insurance but these former guarantors have enough trouble of their own.
Municipal bonds are still much safer than other investments and will always have the tax advantage. This isn’t a warning to avoid all bonds; many are bound to be solid investments. It’s hard to believe yields will continue falling, however, and thus it would be prudent to wait until the ticking time bomb explodes. At that point, I think this next Forbes article gives some good advice on limiting risk…