Municipal bonds are heavily owned by individual investors because of the income tax exemption and they are widely considered to have safety characteristics second only to U.S. Treasury debt. Money has been pouring into bond funds this year, a fair amount of it into municipal bond funds.
Be careful: the credit characteristics of this market are not what they used to be. According to an article in the Wall Street Journal, “over the past decade, municipal debt has doubled, to nearly $2.93 trillion.” Yes, that’s trillion with a T. The article goes on to note that
Over all, state and local governments’ total liabilities—including loans and accounts payable as well as bonds—exceeded their assets by $319.3 billion at the end of the second quarter, the Fed said in its quarterly Flow of Funds publication.
That can’t be good. When your liabilities exceed your assets, you’ve got a big problem. Of course, governments can raise taxes to cover the debt service, but right now that’s like trying to get blood from a stone. Continuing high unemployment is going to make it difficult to convince the electorate that they need to pay more taxes. Additionally, voters are not happy about the continuing ramp-up in local government spending. Since many local governments cannot balance their budgets, they are borrowing even more money to cover the gap. In 2009, muni bond issuance topped $400 billion for only the third time ever ($493 billion), and even more issuance—$560 billion—is expected for 2010. In other words, the hole is already deep and local governments are still digging.
Taxable U.S. investor portfolios are still often cast in the 60% blue chips/40% muni bonds mold. In the past, that has worked pretty well. Maybe it will continue to work in the future, but there’s certainly a possibility that the financial crisis has pushed many muni bond issuers past the tipping point. Portfolios may need to be significantly more flexible and more tactical to navigate the financial markets of the future.
