Are municipal bonds safe? The correct answer is that it depends on who you ask.

Politicians say muni-bonds are still a good bet and credit-raters mostly agree. Rating agencies say that a AAA-rated bond is safer than a B-rated bond, which means the actual credit risk is relative.

Bond analysts, though, are quick to point out that muni-bond defaults historically have been very low. But is the past prologue?

Storm Clouds Hovering

Municipal bonds have long been touted for their tax-free income, but overspending and fiscal mismanagement is pushing states and cities to the brink.

Increasing credit risk is also undermining the tax-free income muni-bonds are revered for. And then, there’s the uncomfortable subject of pension benefits. Under current actuarial assumptions, state and local government pensions are underfunded by roughly $1 trillion.

A pension system is underfunded if its assets are less than its estimated liabilities. Most retirement systems can pay pension benefits for many years out of existing funds, but this does not mean they are sound.

Due to the financial crisis, it’s understandable that we’ve become callus to such large figures: One or two trillion dollars ain’t what it used to be. And while that’s true, it’s absolutely wrong to assume everything will work itself out. More important, local governments, unlike the federal government, can’t print their way out of debt.

For that reason, cities like San Bernardino, Calif., have already declared bankruptcy, and bigger problems for even larger cities like Chicago, Los Angeles and San Jose are on the horizon.

Too Big to Bailout?

Municipal bonds are debt obligations issued by state, city and local governments to pay for their daily operations or to fund specific projects, such as the development of roads, bridges, hospitals or schools. It’s a $3-trillion market and represents around 10% of the total U.S. bond market.

State and local governments spend $2.5 trillion annually and employ over 19 million workers or 15% of the national total.

They represent six times as many workers as the federal government!

Here’s the point: While much of the public’s focus has been on banks that are “too big to fail” – the public and the media have completely missed the other crisis of states and cities that are “too big to save.”

The Outlook

For now, the municipal-bond market (MUB) has been a calm place to invest.

State specific funds linked to California (CMF), New York (NYF) and others have marched ahead.

Money market muni-bond funds (FTEXX) have held steady.

But tax revenues, based upon history, (see chart below) have been volatile and are entering a new phase of even higher volatility. The stars are aligning.

For traders, a break below support for muni-bond ETFs will signal a high probability setup for shorting. Being too late will mean a missed opportunity, and being too early will mean disappointment.

For financial advisors, protecting client capital from the looming debt storm is an absolute must. Stay away from individual issues, especially revenue bonds. And for goodness sake, don’t be piling into high yield muni-bond debt at the worst possible moment of the credit cycle.

Yes, diversifying with muni-bond funds and ETFs is a good start, but more drastic measures may be required.

One source of information on the subject, the August ETF Profit Strategy Newsletter covers the muni-bond market and other markets by identifying key inflection points using sentiment, cash flow, and other indicators.