Today on the online news outlet The Huffington Post, Bernard Condon writes on “How The Municipal Bond Bust Could Do Big Damage.” The article details the recent plunge in interest rates in the state and local government indebtedness marketplace, and speculates about future trends in that area. From the article:
States are scrambling to close $114 billion in budget shortfalls over the next year and a half. For now, they can borrow at curiously low rates in the bond market – but they better hurry.
Lenders are still throwing money at the federal government despite its trillions of dollars of debt. But when it comes to states, cities and local governments deep in the red, their generosity appears to be running out.
Prices of municipal bonds, which are issued to build schools, lay water pipes and pave roads, dropped last month at one of the fastest clips since the credit crisis two years ago. Shares of mutual funds that hold the bonds have fallen hard, too.
Some experts worry that problems in the municipal bond market could spread to other markets. Their worst case: A plunge in muni prices triggers panic among investors and widespread selling of other financial assets. That happened during the 2008 credit crisis, when the market for mortgage-backed bonds collapsed. Credit markets froze and stock prices plunged worldwide. A recession that had begun nearly a year earlier became the worst downturn since the Depression.
The article concludes with forward looking comments:
Municipalities use revenue from taxes, fees and other sources to make interest payments and repay principal when a bond matures. Muni bonds are attractive to investors because you don’t have to pay federal income tax on the interest. That’s not true for corporate bonds. So while top-rated munis maturing in 10 years yield 3.38 percent annually now, that’s more like 5.2 percent for those in the highest tax bracket. If you buy bonds issued in your state, you often don’t have to pay state or local income taxes, either.
Investors tend to buy munis based on the yield and take their chances that the price of their bonds or the price of their muni fund shares won’t fall. Despite the recent drops, bond prices are still up this year. That rise plus interest payments translates into 5.5 percent gain for munis so far this year, according to Barclay’s Capital.
The bullish case for munis is that they almost always make good on their payments. Only 54 of the 60,000 munis that Moody’s Investors Service rated from 1970 through last year have defaulted. But history may not be a good indicator because the finances of local governments are in their worst shape since the Depression.
“Risk is inherent in the unprecedented, not the precedented,” Aronstein says.