Municipal Bonds

In general the investing thought process on risk is:
– US government debt lowest risk (and CD’s)
– then municipal debt, which rarely defaults (often the “nominal” interest rate offered is lower than the Federal rate because it is tax exempt, for the most part, but the “effective” rate is higher)
– then stocks

All things being equal, you’d expect to have a low interest rate on US government obligations (now short-term it is effectively zero or less than 1% unless you go out a couple of years), a modest rate on municipal debt, and then the return on stock prices is a component of the rise in prices (generally expected to be about 10% over time by most commentators) plus dividends (and the growth in dividends).

What people are starting to notice, however, is that municipal debt “earns” that higher return than the Federal instruments by being riskier. The New York Times (which has an excellent business section) had an article titled “Gauging Those Tremors in Municipal Bonds” on January 9, 2011:

(the) benchmark muni index lost 4 percent in the fourth quarter, nearly a year’s worth of income yield for an intermediate-term, high-grade tax-exempt bond fund.

Meredith Whitney recently raised her profile in the media by going on “60 minutes” and describing how we are going to have a “Day of Reckoning” for state budgets. Side note – gotta love Wikipedia – I would have never known that Meredith is married to a former pro wrestler.

I would say that, in general, the nation was taken aback by the fall in home prices and now people have a grim understanding of how the housing market really works. An acquaintance of mine recently said he couldn’t re-finance his home because he didn’t have enough equity in it; and he purchased it in 2002, far from the frothy 2007 at market highs. In the 90’s and up to the mid 2000’s the average person also believed that the stock market could give them 10% returns over time; we have spent the last decade or so essentially flat. Anyone retiring soon or looking at their statement also has seen that the common wisdom isn’t paying the bills.

So I would say that the public will likely awaken sooner to the issues with municipal debt sooner than they did to these other asset class issues. It is strange to say that there is an asset class “bubble” but in some sense there is with municipal bonds because they are able to sell them with such a small risk premium (only a bit above the Federal risk free rate) while they, in fact, have been storing up a great deal of risk.

While the “professional” indicators are seeing red (CDS rates by state), there are new “measures” being tossed about by commentators attached to the status quo (pretty much everyone in government and the muni-issuing community) showing statistics such as “debt to GDP” with the states around 5% while the Federal government is > 70%. The difference is that the crisis at the state level is laid bare; you can’t go to California now and say that there isn’t a debt crisis or in Illinois either; the state of Illinois is not paying bills nor have they made contributions to the states’ massively underfunded pension plans – and the only place they can go to are the state tax payers who emphatically are not excited about putting more money into such obviously un-restructured institutions.

If you have money in municipal bond funds you are subject to many other items driving change than the credit worthiness of the main issuers; you have benefited from the Fed’s policy of dropping interest rates to nearly zero and the Federal governments’ cash infusions into the states as part of the stimulus package. Both of these tides are likely to recede at some point, as well.

In the vast universe of municipal bonds there are huge differences in credit-worthiness and if you select individual bonds and hold them to maturity you won’t face the same issues that the bond funds face, above. However, the fact is that municipal bonds are traditionally priced as if the likelihood of default is remote and over the next few years we will see if, in fact, that is true. If you are holding municipal bond funds, especially those with concentration in risky states (pretty much any state run by a “blue” party right now), you are in effect betting that these defaults are remote and that no risk premium is warranted.

Good luck.

Cross posted at Chicago Boyz


  1. I hold two muni bond funds, both based here in Wisco. While we are not exactly the bellweather of fiscal responsibility, there is pretty small chance of default RELATIVE to our neighbors to the South and Cali. The yields aren’t spectacular, but are solid and are triple tax exempt whichi is a big deal to me.


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