It’s no secret that local and state governments are awash in red ink. And while the financial problems facing them are significant, prophecies of doom have yet to be fulfilled.
What lies ahead for the $2.8 trillion municipal bond market? Will it become the federal government’s next financial bailout? And what’s the best way for bond investors to succeed in this treacherous market?
History on Municipal Bonds
Municipal bonds are debt issued by states, cities and local governments. Since 1839, there have been less than 10,000 investment grade municipal bond defaults out of over 1 million issues. Almost half of these occurred between 1929 and 1937, during the Great Depression era. A widely cited study by Professor George H. Hempel indicates the majority of defaults that occurred during the Depression era were cured within a few years.
Despite the high recovery percentage, many municipal bond investors were forced to sell and suffered large losses during this period.
Today, local governments are drenched with rising costs and falling tax revenue. The cost of healthcare and pension benefits for public workers is sinking them to the point of no return. Historically, investment grade munibond defaults have been rare. But is this time different?
Connecting the Dots
Beneath its surface, the Dodd-Frank Wall Street Reform and Consumer Protection Act has bigger implications for the municipal bond market than meets the eye.
According to the Website for Congress, the new financial bill is intended to “promote the financial stability of the U.S by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Got all that?
What about the bill’s section for protecting U.S. taxpayers from bailing out insolvent or bankrupt states? Did you read that part? If you didn’t, it’s mainly because it doesn’t exist.
This, no doubt, leaves open the possibility of federal bailouts for states. And guess what? The U.S. taxpayer will once again be hooked for the mammoth tab. While this may provide a temporary lift to the munibond market, the lasting benefits are likely to be short lived.
The Best Investment Strategy
What’s the best strategy to play the dangerous municipal bond market? Interestingly, the imminent threat of interest payment defaults has done little to scare munibond investors away. Why? Because they’re (foolishly) too busy being focused on the tax-shelter benefits of munibonds and how their after-tax returns compared to higher yielding taxable bonds can be more attractive.
Munibond ETFs like the iShares S&P National Municipal Bond Fund (NYSEArca: MUB) and the SPDR Nuveen Barclays Capital Municipal Bond ETF (NYSEArca: TFI) which offer broad exposure to a portfolio of various municipalities and states throughout the country, have risen around 4% year-to-date. That’s not exactly crisis-like returns.
Likewise, large munibond mutual funds like the $5.5 billion AllianceBern Intermediate Divers Munibond Fund (Nasdaq: AIDAX) have exhibited a smooth ride so far.
Nevertheless, it’s a big mistake for bond investors to prematurely conclude the worst is over.
Is it any wonder that Warren Buffett recently cut his firm’s municipal bond holdings to under $4 billion from almost $5 billion in 2008?
And is it any wonder that insurance companies refuse to offer protection against municipal bond defaults? Today, just one active bond insurer remains: Assured Guaranty (NYSE: AGO).
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