U.S. Muni Bonds: Investors Are Concerned This Might be the Next Debt Crisis

Dr. David Krause, AIM program director said, "As the investment community carefully watched the sovereign debt and banking crisis unfold in Ireland last month, another potential debt landmine was continuing to surface here in the United States. Municipal bonds could bring some U.S. states and municipalities to their knees - and with the political climate change in Washington DC - I don't believe the federal government is likely to produce another bailout package."

Dr. Krause continued, "This blog has contained previous discussion about the state of municipal bonds, but I think it will continue to attract attention over the next several weeks as investors focus on sovereign and state debt issues; especially now that the national press is beginning to recognize it as a problem."

Source: 12/5/10 NY Times

The New York Times wrote today about the looming state debt in their article, Mounting State Debts Stoke Fears of a Looming Crisis. Michael Cooper and Mary Williams Walsh wrote, "Municipal bankruptcies or defaults have been extremely rare — no state has defaulted since the Great Depression, and only a handful of cities have declared bankruptcy or are considering doing so. But the finances of some state and local governments are so distressed that some analysts say they are reminded of the run-up to the subprime mortgage meltdown or of the debt crisis hitting nations in Europe."

They continue, "Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country." 

Dr. Krause said, "Municipal bonds have long been considered to be one of the safest income investments in the financial market. Munis are bonds issued by government units, such as states, cities, counties, and local school districts for capital public projects like roads, bridges, sanitation plants, schools, etc. Historically they have been extremely safe with a default rate of less than 0.1% since 1970; however, things are changing with large deficits and huge unfunded pension liabilities."

Source: 12/5/10 NY Times

"State governments in the U.S. are running major structural deficits," Dr. Krause continued. "California, Illinois, New Jersey, New York and Michigan are the most glaring cases, but many other states and local communities are hurting as well -- and the bond market has begun to price this into the required yields."

The NY Times' Cooper and Walsh wrote, "As the downturn has ground on, some of the worst-hit cities and states have resorted to fiscal sleight of hand to stay afloat, helping them close yawning budget gaps each year, but often at great future cost. Few workers with neglected 401(k) retirement accounts would risk taking out second mortgages to invest in stocks, gambling that the investment gains would be enough to build bigger nest eggs and repay the loans. But that is just what Illinois, which has been failing to make the required annual payments to its pension funds for years, is doing. It borrowed $10 billion in 2003 and used the money to invest in its pension funds. The recession sent their investment returns below their target, but the state must repay the bonds, with interest. The solution? Illinois sold an additional $3.5 billion worth of pension bonds this year and is planning to borrow $3.7 billion more for its pension funds."

Tax-exempt muni bonds in November had their worst monthly returns of 2010 as rising Treasury yields and high municipal fixed-rate debt sales resulted in withdrawals from muni bond mutual funds. Tax-free bonds lost 2.3% in November, the third consecutive monthly drop and the longest slide since 2004, according to the Bank of America Merrill Lynch Municipal Master Index. Mutual funds investors pulled $5.4 billion of muni assets within two weeks last month, according to Lipper FMI, a research firm.

Dr. Krause added, "This market bears close watching. The same concerns European sovereign debt holders have faced this year are likely to be shared by U.S. municipal bondholders in 2011."