The Seven Deadly Risks in Muni Bonds

10/28/2010 12:00 pm EST

Focus: BONDS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Doug Fabian, editor of High Monthly Income, says municipal bonds have had a great run, but their hidden risks are much bigger than most investors realize.

Whether you own individual municipal bonds or municipal-bond mutual funds, you’ve likely had a good year. In fact, muni bond prices have risen to historically high levels during the past 18 months.

Yet, in my opinion, muni investing is going to get much more difficult. Some investors even may lose principal and interest if they have not policed their muni holdings properly.

With bond prices at all-time highs and interest rates near all-time lows, now is the time to do your homework and make sure you don’t get caught in the coming write-down of municipal bonds.

Not all municipal bonds are at risk. However, a significant portion of the muni bond landscape is susceptible to some very serious dangers. I’ve broken down these dangers—risks, if you will—into seven categories.

  1. Interest rate risk. Interest rates are at all-time lows and bond prices are at all-time highs. Long-term rates are poised to rise on the back of a huge supply of bonds from the US government, and that’s not good for munis.
  2. Tax revenue is shrinking. Since 2008, state tax revenues have been shrinking, and real estate taxes are dropping due to lower property values. Because munis rely heavily on state tax revenues to fund their bond payouts, a continued decline in revenue could put munis in jeopardy.
  3. Fraud. The city of Bell in California’s Los Angeles County is ground zero for city government fraud.  I think that there will be more municipal fraud like this uncovered, and if governments choose not to play by the rules, then the bond market will punish them.
  4. Rating agency failure. How can you trust entities that missed the largest bubble of all time? Their track records of rating mortgage-backed securities don’t mean much. This isn’t too comforting for muni bond holders.
  5. Mutual funds hold suspect debt. During a recent analysis of a broker-sold bond fund, I discovered that the fund was holding 40% of its securities in unrated issues! Now, that’s what I call risk.
  6. Lack of oversight from brokers. Full-service firms lack the attention to detail that is required to rate a bond portfolio today. These firms rely on the ratings agencies and, as we’ve already seen, these agencies don’t do proper due diligence.
  7. Public pensions. A recent report pegged the pension liability of public employees at $3 trillion. In many cases, cities and counties will need to redirect funds to pay for these shortfalls, making the risk of muni bond default a serious concern.

These seven reasons are really just the tip of the iceberg when it comes to muni-bond risk, and they are things you need to consider if you hold these securities.

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