Muni-Bond Myth: California Is Greece

Tax-free muni fundamentals look promising as budget gaps narrow

   
Muni-Bond Myth: California Is Greece

While benchmark 10-year Treasury notes have been grabbing all the headlines this year by plunging to all-time record lows, tax-free municipal bonds have quietly been delivering the goods, too.

The S&P Municipal Bond Index is up 1.72% for the quarter-to-date and has gained 3.86% so far this year. At the same time, the most popular muni-bond exchange-traded fund, the iShares S&P National AMT-Free Municipal Bond ETF (NYSE:MUB) has climbed 1.8% for the year-to-date, and currently sports a yield of 3.2%.

Throw in the tax-free benefits of munis, and they’ve been a rock-solid contributor to fixed-income portfolios.

Of course, the knock on munis is fear that recession-plagued borrowers will default. It’s no secret that state and local governments face their biggest budget shortfalls since the Great Depression. Headlines about Alabama’s Jefferson County displacing Orange County, Calif., for the dubious distinction of the largest municipal bankruptcy in U.S. history sure don’t instill confidence. Neither do Vallejo, Calif.; Stockton, Calif.; and Harrisburg, Pa., all of which missed debt payments.

And when entire European nations like Greece need bailouts, well, it’s natural that retail investors might look askance at debt issued by authorities here at home. Just consider the ugly finances of the largest state in the union, California. Its economy is as big as Italy’s and six times larger than Greece’s. Surely, widespread defaults in the Golden State would wreak havoc on confidence in the muni market.

But California — and, indeed, any other state government — is not Greece, note the fixed-income strategists at Charles Schwab (NYSE:SCHW) Center for Financial Research. Heck, not even close. Sure, it’s an easy comparison to make, but the differences are far more important than the similarities.

For one thing, state and local governments do not generally borrow to fund deficits, Schwab notes. Indeed, states can’t borrow to fund deficits over multiple fiscal years without having to jump through a host of legal and political hoops.

Additionally, states generally don’t build up debt for operational purposes, Schwab says, and debt service costs usually account for no more than 3% to 5% of government expenditures.

Yes, the downside is that state and local governments have to slash their budgets when revenues come up short. They also desperately try to hike taxes. It’s a painful and ugly process for citizens — just witness the upheaval in California.

“[But] every state except Vermont requires balanced budgets, unlike the federal government (or, for that matter Greece),” Schwab strategists write.

That enforced fiscal discipline helps ensure that muni-bond holders get paid.

Furthermore — and this is critical — unlike Greece, state revenues are improving while budget shortfalls are in decline.

The U.S. Census Bureau reported that all 50 states saw an increase in total tax revenue in fiscal 2011, notes the muni-bond team at BlackRock (NYSE:BLK). Total state tax collections increased 8.9% to nearly $764 billion — the highest total since a peak of $781 billion notched in 2008.

Also, as the Schwab team notes, for the coming fiscal year, 30 of the 50 states project $54 billion in total shortfalls that need to be balanced, down from a high of $191 billion in deficits closed with spending cuts in 2010.

“The ‘gap’ between the revenues and projected expenditures continues to narrow,” says Schwab. “The opposite is the case in much of the eurozone, where many countries are on the verge of if not already in recession.”

Lastly, and perhaps most important, state and local budget battles are a far cry from riots, capital flight and the potential for economic collapse. “While state and local governments face challenges in the wake of the Great Recession, no U.S. state has built a level of excess debt and extreme lack of competitiveness or lack of proactive budget management as Greece,” Schwab writes.

Bottom line: It’s easy to compare California to Greece, or pretty much any troubled local or state government to one of the wobbly eurozone nations. But it’s not really all that helpful.

With state revenue collections at their highest level since 2008, muni-bond fundamentals look promising, BlackRock says. Income-thirsty investors keep lapping up their yields (and tax benefits), meaning demand for the asset class remains robust and should continue to outstrip supply.


Article printed from InvestorPlace Media, http://investorplace.com/2012/06/muni-bond-myth-california-is-greece/.

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