High yield bonds, often known as junk bonds, have been very popular investments since the financial ...
The Case Against Munis
02/10/2009 1:00 pm EST
Gary Shilling, editor of INSIGHT, cautions investors that the recession is hitting state and local governments hard, making municipal bonds less attractive.
Municipal bonds, along with almost all investments last year, were clobbered by the credit crunch and the resulting flight to the quality of Treasuries.
The selloff in low-grade munis and their cheapness relative to Treasuries may make them seem attractive. Investment-grade munis may look like screaming buys. With 30-year Treasury bonds yielding 3.4%, 5% yields on comparable-maturity triple-A muni bonds may appear too good to resist.
Still, the economy is in the midst of what will probably be the most severe financial crisis and deepest recession since the 1930s. A rerun of the municipal defaults of the 1930s is unlikely. Debt ratings [are] tougher for municipal obligations than in the 1930s, when almost all were rated triple- or double-A.
Furthermore, unlike the 1930s, today bailouts are the order of the day, and state and local governments are lining up for their fair share of government handouts—and the Obama Administration is responding [in] its fiscal stimulus plan
Nevertheless, in many ways, state and local governments are more vulnerable to a very severe recession and financial crisis than they were in the 1930s [because of] the rapid growth in state spending in recent years and leap in debt.
Jumping municipal employment is the main reason for mushrooming budgets. And since the 1930s, municipal employees have become largely unionized. That makes labor costs essentially fixed and extremely difficult to cut through layoffs or other means. Also, pensions and medical benefits are extremely lush. Recent portfolio losses by state and local pension funds foretell increasing government costs in future years.
As sales taxes and corporate income taxes drop, personal income taxes sag and mortgage foreclosures mount, around two-thirds of the states have cut their budgets to the tune of $53 billion so far. Despite these cuts, revenues are falling so rapidly that state and local deficits are leaping. For the rest of this fiscal year as well as 2010 and 2011, the red ink could reach $370 billion.
Personal incomes and taxes are weakening as unemployment mounts. Sales taxes will continue to drop as consumers retrench. And property taxes are extremely vulnerable as house prices plummet. The outlook, then, for state and local finances is grim. The recession and financial meltdown are shrinking their revenues much faster than they are cutting costs.
[That’s why] the quality of many municipal obligations will be under fire, and numerous rating downgrades can be expected, even if municipal bankruptcies are limited. Rating agencies will probably be very aggressive in slashing ratings after being so embarrassed in missing the subprime-mortgage boat.
So, if you are tempted by high yields on munis, stick to the best and do your own homework on their financials, especially if you want to buy General Obligations backed by the taxing power of the issuer.
Normally, GOs are considered safer than revenue bonds backed by specific revenue such as bridge or highway tolls. But maybe the reverse is true in some cases in the current recession and financial mess.
In any event, be careful!
Related Articles on BONDS
It’s important for traders to watch various resistance levels like we have in the Dow right no...
Guggenheim’s sale of their ETF business to Invesco has been completed, and the BulletShares fu...
In early March, the 10-year yield was circling 2.87%. Now it is circling 3.00% for the first time in...