The Rising Dangers of Muni Bonds

Focus: BONDS

Municipal bonds used to be a rock-solid asset, but in these times of fiscal austerity and economic doldrums, these "widows and orphans" instruments now have a very keen edge that investors need to understand, writes Neeraj Chaudhary of Euro Pacific Global.

Municipal bonds have long been viewed as a staple asset class for conservative, income-seeking investors.

"Munis," as they are known, are a large, liquid market of credit-rated securities that provide tax-exempt (from Federal taxes) income to millions of American investors. Towns, school districts, and other public sector authorities across the country have issued an estimated $3.7 trillion worth of these bonds.

But so far this year, three municipalities in California (San Bernadino, Stockton, and Mammoth Lakes) have declared bankruptcy, and are now asking their bond investors to take reductions in the principal and interest payments they are owed.

Just last week, that club appears set to welcome another member as Atwater, a central California city with a population just under 30,000, declared a fiscal emergency and put itself on a path toward bankruptcy. After the Atwater announcement, NBC news reported that one public finance expert had described municipal bankruptcies in California as "spreading like a disease."

According to recent reports from Moody's and Fitch's, these recent bankruptcies may only be the beginning. They warn that after decades of steady performance, municipal bonds (and by extension municipal bond funds) may see higher default rates and poorer performance in the years to come.

If the economy continues to languish in the years ahead municipal bond holders may find themselves in a tight spot.