A recent Wall Street Journal article warned of the growing risk in the $2.8 trillion municipal bond market. State and local governments are running huge deficits, tax revenue is down sharply and many municipalities are underwater. Harrisburg, PA, Vellejo, CA and Central Falls, RI have all flirted bankruptcy. But bond yields and ratings don’t seem to reflect this worry, the WSJ article points out. Could this be the making of another crisis along the same lines as the subprime mortgage disaster when apparently low-risk securities turned out to be junk?
We believe that the fiscal crisis of state and local governments is grounds for serious concern, but investors can still take advantage of carefully selected municipal bonds. Despite the recent troubles, municipalities rarely default. According to Moody’s of the 18,400 municipal bonds it rated between 1970 and 2009, only 54 defaulted. And even among those that did default, the recovery rate is significantly higher for munis than for corporate bonds. Governments tend to have more sources of revenue to tap into in tough times than corporations do. They can raise taxes or take all kinds of cost cutting measures as Hawaii did when it switched to a four day school week last year, or as California did when it told companies they must pay 70 percent of their 2010 taxes by June. Municipalities are unlikely to put at risk the availability of future financing by defaulting.
With taxes on the rise for high net worth investors, tax-free municipal bonds are more important than ever. There may be trouble in the muni bond market, but there is an enormous variety in bond type, geography, maturity, etc. and so you cannot paint the
market with a broad brush. By choosing the safest, highest quality issues, investors can lock in significant tax benefits at a low risk.