Concerns About the Municipal Bond Market Rise

 

Various well-respected market followers are beginning to sound alarm bells regarding municipal bonds and municipal bond funds. Investors and financial advisers are encouraged to take heed and proceed with caution.

Initially, on the December 19, 2010 “60 Minutes” television show, Meredith Whitney, who had correctly predicted the recent Great Recession, made another call predicting massive defaults of state and local governments: “You could see fifty to a hundred sizable defaults, ‘. This will amount to hundreds of billions of dollars’ worth of defaults.”

While this has not yet happened, Ms. Whitney is unapologetic, her view apparently unchanged. She may ultimately be proven correct except as to timing. While the controversial financial analyst may have had ulterior motives in making her splashy prediction, she is not alone. Warren Buffet has also warned of disaster in the municipal bond market, as has George Soros. Nouriel Roubini (“Dr. Doom”) has said $100 billion in municipal defaults will occur over the next five years. (“The Prophet Motive,” Wall Street Journal Magazine, October 2011).

Lately more experts have been jumping on the bandwagon.

SmartMoney magazine is warning that municipal bonds are overbought and due for a correction (“Are Muni Bonds Still Smart?”). Municipal bond funds were the place to be in 2011, gaining an average of 9 percent compared with the S&P 500 stock index’s 2.1 percent gain. The bears point to: (i) a proposed elimination of the exemption from federal income tax of gains from municipal bonds; (ii) the Volcker Rule, which would limit proprietary trading by big banks and thereby reduce demand for municipal bonds; and (iii) the recent rise in popularity that has increased muni bond prices and lowered yields. “We’ve had yield plus price appreciation because the market has rallied ‘ [b]ut I encourage people not to expect [both] from municipal bonds going forward, one municipal bond expert was quoted as saying.

In addition, InvestmentNews is reporting that top money manager BlackRock Inc. is warning that municipal bonds are facing the threat of “super downgrades,” that is, being downgraded multiple notches. “We’re expecting a radical change in the methodology of the ratings agencies because of Dodd-Frank,” Peter Hayes, head of municipals at BlackRock, was quoted as saying. The spreads between higher-rated versus below-investment-grade municipal bonds are so “dramatic” that a severe downgrade may cause prices to plummet, Mr. Hayes added. (“BlackRock: Munis face threat of ‘super downgrade,'” InvestmentNews).

Moody’s Investors Service also has a negative outlook for municipal bonds as state and local governments, still struggling with revenue shortfalls, face credit rating downgrades. Federal-aid cuts, medicaid and pension costs, depressed real estate values, high unemployment and low consumer confidence are contributing factors(“Moody’s is positive muni outlook negative”, InvestmentNews).

While the risk of defaults remain low, especially for tax-backed general obligation-bonds, which comprise about 40 percent of the market, the risk of lower municipal bond prices in 2012 is significant. (“A Year of Fear for Muni Bonds,” Wall Street Journal). Yields are very low and the yield spread between municipal bonds and U.S. Treasuries with comparable maturities has shrunk to just one percentage point, despite the fact that municipal bonds are less liquid than Treasuries and often provide poor disclosure of material facts.

Investor attorney J. Boyd Page cautioned: “Investors need to be very careful because there are not a lot of safe havens. Despite their popularity, municipal bonds and muni bond funds have their risks. Financial advisers need to be scrupulous in explaining the risks as well as the potential benefits of investments.”

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.