A report was renectly issued, by David Nowakowski and Prajakta Bhide at Roubini Global Economics. It said Muni debt problems aren't "systemic". It said they won’t "infect the financial system." It said there could be close to $100 billion of municipal-bond defaults over the next several years as Muni debt problems occur. Their forecast is less of a concern than that offered by bearish analyst Meredith Whitney.
My own philosophy about investing is that there is too much respect paid to the long term default history and not enough analysis weighted towards current unsustainable cash flow solvency issues. Also, any type of bonds are tool to be used as what Andrew Smithers called a “sanctuary asset” for investments funds that need to be sheltered from the risk of equities. Therefore, unless a bond is of investment grade then one should avoid them. Further, due to the opaque nature of the Muni bonds they are less secure than corporate or mortgage debt. There is too much probability that Munis could come right to the edge of failure and then somehow pull off a last minute rescue by doing a one-time asset sale to raise cash, which would not solve their problems over the long run. A bond that is somehow “safe” because of its ability to squeak through a crisis is not the same quality as a bond back by the income stream of a well-run, solvent corporation. People want to imagine that because Munis having taxing power that somehow they can never fail but is not correct. Munis tend by viewed by investors as an asset class, that despite credit quality weakness, will somehow avoid default. My opinion is that the difference between corporate bonds versus Munis is that corporates have more of a gradual “gray area” buffer zone before the risk of failure, where by contrast, Munis have a sharp binary aspect of either “survive or fail” with the presumption by investors that it would be too dramatic to fail so investors simply ignore the risk of a negative outcome by assuming it would not happen.
Munis issued by weak governments are not going to magically improve in credit quality. If the Eurozone governments decide to have a sovereign default this could scare some U.S. based Muni owners into a selloff.
I prefer that the long history of Munis not defaulting be weighted very lightly and instead their current financial health and political economy should be more heavily weighted in evaluating them. Suppose you are a loan officer evaluating a loan from application for Mr. X and he said he never had any late payments for 40 years. That is not as important as the fact that Mr. X changed last year careers and quit his safe engineering job and bought a very risky business and is now struggling to survive. The nature of government changed in the 1930’s from free enterprise minimalist government to the modern Welfare state and then in the 1960’s during LBJ’s Great Society the nature of most state, federal and county and city governments fundamentally changed to become fast growing entities with expenses that grew faster than CPI or population. I remember in California in the 1960’s we had no state income tax, a 3% sales tax, 2% property tax and a solvent government. Today we have 9.3% income tax, 9.8% sales tax, a property tax of roughly 1.3% (but with valuations skewed in favor of those who bought a long time ago) and a very insolvent government. The fundamental nature of government spending has changed in the past forty years and the beneficiaries of the spending are too addicted to it to give it up. Taxes have risen far higher than imagined forty years ago. So please don’t cite the past 200 years of almost no Muni defaults, instead examine the last 20-40 years of rapid spending increases and tax increases and ask yourself, is it sustainable? Do people with high income become discouraged about earning and spending in California and move away or retire at lower tax brackets in reaction to this? No corporation, either privately held or publicly traded would operate this way. If they did their bonds would be rated as junk.
If an individual borrower had a perfect credit score for the past twenty years while holding a stable job and now in the past year he has been unemployed and living off his credit cards and now has a weak credit score due to high debt balances then his nature has fundamentally changed and his past 20 years of good behavior are of too minimal relevance to be used to assess the safety of loaning money to him. Lending is based on a presumption that good credit behavior of on time payments is a pass-fail screen and if they pass that screen then what really matters is examining recent, relevant cash flow. So please stop saying “because there were minimal Muni defaults in 200 years it will never happen”. That attitude is what got banks into trouble when they bought home loans thinking that since real estate had never gone down significantly in a century then it must be risk free to make loans to anyone regardless of how unqualified they were. There is no comparison between the pre-1965 pattern of government spending and solvency versus the current era of excessive government spending. The fact the California state and local government entities allow lucrative final year pension spikes or final year salaries to determine pension payments and then makes the pension payments inflation adjusted is such a huge change from the standards that existed before the 1965 Great Society era. Similar excesses may exist in other states besides California.
I have written about Munis here and here.
Please use independent investment advice to evaluate the risk of investing.
Excellent article by Bob Carney at CNBC today about Muni bonds. See www.cnbc.com/id/41604499 He basically is holding the same viewpoint as I do, saying that Muni bonds are riskier than they seem. The article mentioned the huge increase in Muni debt. It did not mention that there is also a huge amount of unfunded contingent public employee retiree pension and health care liabilities. For example, California has $500 billion of unfunded pension liabilities that do not show up as debt, which is one-sixth of the nation’s total Muni debt. My philosophy about bond investing is that bonds should be what economist Andrew Smithers called a “sanctuary asset”. This means that bond investors should avoid risk and thus shun junk bonds, including any type of high yield bond. Since Munis in some cases now yield 9after adjusting for taxes) about the same as junk bonds then those Munis are, according to the market, junk bonds. The purpose of bonds is that they are a tool that must be used properly, just as a construction worker must use a work tool for the purpose that it is intended so that an accident does not occur because the tool was used incorrectly. We know what happened when subprime loans were deceptively bundled into MBS and falsely labeled as AAA paper. That was an example of a tool which was used incorrectly that resulted in injury to the investor. So avoid investment injuries and avoid risk by refusing to buy junk bonds. The whole reason to own bonds is to have a sanctuary asset that will not loose value during a crash, but corporate junk and high risk Munis will loose value during a crash. The reason you need bonds is to be able to stabilize your stock portfolio with a low-risk investment and to have a source of funds to use to buy stocks during a crash. The rationale that Munis won’t fail is based on some cliff-hanging scenario where the issuer will just barely avoid default by taking desperate measures to make the minimum debt payment, but that is not the safe and correct scenario for investing in bonds, instead you need to own high quality bonds which have a comfortable margin of safety in terms of the issuer’s ability to make payments. This is my independent investment advice about Muni bonds.