Investors should run, not walk, away from low-quality munis, such as these highlighted on the wall of shame of Marilyn Cohen of Envision Capital Management.

Some people have nightmares about being chased by runaway trains, vicious animals, or bad guys. Mine is a daytime nightmare: Being chased by molten lava.

The lava in this case is the red-hot viscous bad news still emanating from the municipal bond market. This daymare won't end for municipal bond investors until the lava solidifies. It won't end until the geographically spotted bankruptcies cease; until unfunded pensions are resolved; until the courts rule; and until the restructuring begins. All the while, the flow is slow, and anything it touches gets scorched.

You read the papers and see what's happening in Detroit, Stockton, San Bernardino, Chicago, and Puerto Rico. The sound and fury, posturing and bluffing, may appear a bit different in each case, but the subliminal outcome is the same—bondholders must share in the pain and take a haircut.

Like a lava flow, taking a haircut on your municipal bonds—even one position—is destructive. But like a lava flow, casualties should be rare because the information and process is slow enough to allow escape. Your escape route is clearly defined: Sell those municipal bonds whose headline risk is untenable.

Take the City of Detroit. Things are terrible. The city's population fled, leaving a low tax base, unions that won't negotiate, and people in power that are in denial about the depth of the financial problems. In other words, a city careening towards financial collapse.

Yet...some short-term Detroit general-obligation bonds traded at 84 cents on the dollar, or $840 for every $1,000 face value. This disconnect between price and yield—versus the financial facts—is unfathomable, even though most of Detroit's bond debt is tied to water and sewer-not general-obligation bonds.

And if my words don't make an impact on you, go online and look at photographs of Detroit. It looks more like Beirut than an American city. That explains everything.

A recent Moody's report correctly points out that Detroit's emergency manager has been using the words "fair and equitable" when describing his restructuring strategy. Moody's states, in plain English, that this means bondholders will take a hit.

Even though the US economy is healing overall, there are festering cities and states (can you say Illinois?) whose risk versus reward is not in your favor. There's also enough municipal bond consternation going on that you can't control:

  • The Obama proposal of a 28% limitation on municipal bond income on new and existing muni bonds
  • The threat that municipal bonds held by property and casualty insurers will no longer be tax-free (their holdings represent $330 billion out of $3.7 trillion)
  • And the threat that the governors and mayoral lobbies won't have the ability to fend off the Obama administration's grab for increased taxes on the back of the muni market

So buy high and sell low! That is, only buy high-quality municipal bonds and sell the low-quality munis you own. And don't listen to the talking heads pontificating that general-obligation bonds are safe and secure. That was true in the "old days," but no longer.

The great American municipal bond restructuring is selectively in process—like a slow lava flow. Run away and sell those issues that may scorch your portfolio.

Read more from Envision Capital here...

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