From the September 2012 issue of Research Magazine • Subscribe!

August 23, 2012

Muni Crisis Brewing?

Up until now, investing in municipal bonds has been a calm experience. Politicians and credit raters have assured the public that munibonds are safe. But tremors are appearing.

The State Budget Crisis Task Force released a July 17 report showing how six heavily populated states (California, Illinois, New Jersey, New York, Texas and Virginia) are in fiscal turmoil.“The trajectory of state spending, taxation, and administrative practices cannot be sustained,” said the report.

The task force listed threats to the fiscal health of these states and others, including growth of Medicaid spending, underfunded retirement promises, narrow and eroding tax bases, the impact of federal deficit reduction, stresses on local governments, and state laws and practices that mask imbalances.

State and local governments spend $2.5 trillion annually and employ over 19 million workers, which is six times as many workers as the federal government. Is the munibond market the next crisis?

Case Study: California

California is home to 37 million Americans and is a case study in fiscal insanity. On Nov. 16, 2011, the Office of Legislative Analyst released a report forecasting a budget deficit of $3 billion at the end of 2011-12 and an operating shortfall of $9.8 billion by 2012-13.

Today, California’s actual budget deficit is now a $16 billion headache (up from $9 billion in January) and the state’s cities are going bankrupt. (See Mammoth Lakes Stockton and San Bernadino).

Instead of buckling down, California lawmakers approved a $68 billion project to build a high-speed train connecting Los Angeles and San Francisco. (A flight from L.A. to S.F. takes about one hour and costs around $100 one way.) Interestingly, the approval allowed the state to collect $3.2 billion in federal funding that would’ve otherwise been rescinded. The federal government rewarded California for needless spending projects, leaving U.S. taxpayers on the hook.

California’s experimental plan for cutting its massive budget holes involves increasing taxes.

Gov. Jerry Brown (D.) wants California voters to approve “temporary” tax increases on the highest income earners along with the sales and use tax rate by 0.5%. The vote is set for November 2012 and informed observers know that there’s nothing more permanent than a temporary tax increase.

California may be an extreme example of the fiscal challenges facing states, but it’s still a good representation of big problems ahead.

Red Flags Everywhere

Instead of cutting spending, states and cities are borrowing more. U.S. municipal bond issuance is already 69% higher through the first six months of 2012 compared to the same period in 2011. Although declining interest rates has given struggling counties, cities, and states more time to get their financial house in order, how can they borrow themselves out of debt?

More crucially, the borrowing capacity for states and cities is not the same as for the U.S. government. An insolvent state, for example, cannot print its way out of debt. For this reason, the order of massive bond defaults probably first happens in the municipal bond market and eventually in U.S. Treasuries—not the other way around.

Finally, asset flows into bond munifunds currently suggest investors are either complacent or ignorant. Through the first half of 2012, investors have sunk $31.56 billion in munibond funds. Not only does the existing pace easily beat last year’s, but it’s 40% more than the record inflows experienced during the first half of 2009-10. Asset flows suggest an unsustainable peak.

Strategic Options

Over the past two years, national munibond yields have been nearly cut in half. At the same time, credit risk is increasing with cities and states on the brink. Instead of compensating bond investors with higher yields for shouldering the additional risk, national munibond yields have collapsed to around 2%. How can you navigate this difficult environment?

Some advisors have decided to only use insured munibond funds like the PowerShares Insured National Munibond (PZA). Insurers guarantee payment of principal and interest in case the bond issuer were to default. In 2007-08 when credit rating agencies began downgrading municipal bond insurers, the market started to price even insured munis based on their underlying ratings. At that point, bond insurance added little value in the municipal market.

One final strategy is to avoid state specific munibond funds altogether by sticking with nationally diversified funds like the iShares S&P National AMT-Free Munibond (MUB). Although it may constrain tax benefits, it could significant reduce credit risk by diversifying across multiple regions.

In summary, the munibond market looks poised for trouble, but preparing clients for the rough ride ahead will give them confidence in your ability to steer them in the right direction.

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