In this article we’re going to discuss the reasons why Municipal Bonds are a safe investment and belong in your portfolio. We have previously covered reasons why Municipal Bonds are a bad investment. Understanding the pluses and minuses of Municipal Bonds allows you to make an educated decision on investing in this category.
There were 19% less municipal bond offerings available in 2010, mainly due to the emergence of the Build America Bond program. With less supply available, demand is chasing the smaller pool, hence pricing can remain firm. When and if this program terminates, this will no longer be true. Merrill Lynch expects Muni yields to rise 0.35 – 0.50 percentage points without the program.
Demand is increasing
With America’s growing deficit, tax rates will almost inevitably rise for the wealthy. Municipal bonds are one of the last tax havens for affluent investors.
Defaults Are Undesirable
If a municipality defaults on a municipal bond, it will be hard for them to raise money any time in the near future. This fact forces municipalities to do everything they can to satisfy bondholders. Municipalities can balance budgets, raise taxes if necessary, cut programs, and cut benefits. Tax revenue often lags the broader economy, because people don’t file their taxes until April of the following year.
Few defaults and bankruptcies
Even if they default, there was 97% default recovery rate on municipal bonds during the Great Depression. Given time, municipalities can increase taxes, fees, fire workers, and take drastic steps to fulfill obligations. Municipalities have frameworks to work through restructurings. Unlike some European countries who roll over debt, municipal debt has to be paid off every year.
Prices are holding steady
Although there are occasional glitches, prices have been holding steady last couple years, with all the bad news being tossed around. Municipal bonds are not like.com stocks. Municipalities cannot really disappear. This distressed area is 100% visible to the public unlike the housing crisis.
Need to be selective
As we’ve mentioned in the past, it is very important to the highly selective in selecting your municipal bonds. Investors need to monitor reports and news on specific locations or projects, especially if they buy individual bonds. Over the last 10 years, 96% of the municipal market experience credit rating changes. Revenue muni bonds backed by solid streams of income may be safer.
State debt Service
Debt service accounts for low percentage of most state budgets. California spends 4%, New York spends 4%, while Connecticut spends 5%. Many state constitutions require repaying debt be the number one or two spending priority. Budget shortfalls have stabilized. Tax collections are going back up after large dips in 2008 and 2009. The combination of debt and pension contributions utilize 9% of California’s budget, 8% of New York’s, and 17% of Illinois. States can take action to close gaps, if there is political will or if they are forced to. They can raise taxes, raise property taxes, raise retirement age, cut benefits, cut spending, pay more in good times, and Rainy day funds in bad times. Illinois increased state taxes to help cover budget shortfalls in 2011. States can also reduce retirement benefits or raise employee contributions. See this WSJ article for a map showing strong to weak states.
Deficit reduction bonds were used in Massachusetts in 1990 two bridge large budget deficits. It is conceivable that this technique will be used again.
Municipal debt is fully amortizing, with both interest and principal payments included in operating budgets of municipalities, and municipal bond issuers aim to achieve level or declining debt service, according to Moody’s and Citigroup reports. Corporations and nations such as Greece or Portugal borrow money that must be paid back in one lump sum when the debt comes due. This makes them a lot more vulnerable to rapid shifts in markets as they need to tap credit markets often to refinance existing debt. Most states spend 5 to 7% of their expenditures to pay for debt service, compared to 15% for Greece. The budget gaps of some of the most fiscally challenged States is less than 2% of their GDP.
Most states and municipalities don’t rely on short-term borrowing like Lehman Brothers did. They owe long-term debt. , California, usually borrows each year to cover seasonal shortfalls, as does Illinois. These 2 states are forced to deal with the credit markets and accept terms when they need money.
In a recent settlement, Vallejo, California, California state controller, and the bond insurer, agreed that in event of default, the insurer could access some of the funds that California distributes local governments. This is significant because it upholds the right to access to money that helps backstop many municipal bonds.
What if all the above is null and void? A federal bailout of the state is probably likely. Keep in mind that the Federal Reserve is currently limited by law to only buying certain kinds of very short term Muni debt.
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