As panic has come over the muni market with widespread fears of default at all levels, many municipal bond investors are still ignoring warnings forecasts of possible defaults and are relying on the fact that a huge portion of the municipal bonds issued are “general obligations” of the states and cities issuing the bonds. Although the default rate historically on general obligation bonds has been small – only three defaults have occurred since 1970, this may change.
“Tax supported” munis, which are bonds that are backed by general tax revenues, compose about $1.8 trillion of muni debt and have previously been considered virtually risk free. However this may no longer be the case as state and local governments are facing financing crunches in the midst of a politically and economically changing atmosphere. Historically, muni debtors have chosen to raise taxes or default on pension obligations to make municipal bond holders whole. The economic and political atmosphere has shifted to make this less likely.
Politically, in the aftermath of the recent financial crisis and bailouts, tax hikes are unpopular. Moreover, cuts to local spending or slashing public pension funds are not as easy as they once were.
Economically, debt burdened states and localities find it hard to raise taxes to fund their debts because their tax bases have been devastated. States have seen their core economic sectors hollowed out and see little recovery in sight. According to a study by the Washington-based Center on Budget and Policy Priorities, 44 states face a combined $125 billion of budget deficits next fiscal year.
The combination of these factors has added substantial risk to investing in municipal bonds. Investors should carefully evaluate the financial condition and wherewithal of issuers when considering an investment in municipal bonds.
Many investors have already observed these developments and acted accordingly. For a 13th straight week, investors withdrew substantial monies from U.S. municipal-bond mutual funds. According to data released yesterday by Lipper, a Denver-based research company, investor withdrawals have totaled $24.8 billion since mid-November.