Apocalypse Coming in Muni Bonds?

Apocalypse Coming in Muni Bonds?

By Christy Heady

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Justin Sullivan, Getty Images

There's a hotbed of controversy in the municipal bond market. 

Even with ballooning budget deficits in cities and states across the U.S., recent defaults in California, and increased speculation by a few bond analysts calling for a future meltdown, investor demand for safer yields in the muni space is expected to increase.

And these aren't the only ingredients to the paradox.

Municipal bonds could also lose their tax-free status, depending on what happens in the November elections.

What exactly is going on?


Pay the Bond Holder or the Sanitation Department?

Municipal bonds are securities sold by states, counties, cities and other political entities (such as airport authoritiesand school districts) other than the federal government and its agencies.  There are two types: general obligation bonds (GOs) and revenue bonds.  GOs are backed by the full faith and credit of the issuer, and tax the residents to pay for the bond interest and principal.  Revenue bonds are repaid from the money generated by the project they were sold to finance, like a toll road.

Historically, there are very low levels of default and an even lower level of bankruptcy.  Municipalities don't want to jeopardize their access to the capital markets, so now they are making cuts in their budgets and reining in long-term liabilities through pension reforms after being financially squeezed by rising costs for labor, pensions and retiree health benefits. 

It's a positive move toward a state's future credit worthiness.  Municipal Market Advisors, a watchdog for the sector, says 42 municipal issuers have defaulted for the first time this year, which is actually down from 68 in 2011 and 83 in 2010. 

For cities in California like Stockton, San Bernardino and Mammoth Lakes... it was too late.  They all filed for bankruptcy protection just weeks apart this past month.  In California, the phenomenon may grow.


Will Their Allure Remain Forever?

Because of the belt tightening, the number of new issues are decreasing.  Municipal Market Advisors reports that 50% fewer new muni issues are available this year versus last year.

For the past few years, Congress has floated the idea of reducing or eliminating the muni-bond tax break as a way to implement a tax overhaul and deficit reduction.  With the tax break, issuers could sell bonds to individual investors at lower yields.  That kept demand high and borrowing costs low.

Depending on what happens in the November elections, that all could change. 

With a shortage of supply and investor demand growing for safer yield, investors need to be forewarned that new issues in a muni bond or muni fund may not retain its tax free status forever. 

For now, muni bond yields beat yields on Treasuries.  Typically, it's the other way around. 

If You Want to Weather a Potential Storm...

The municipal market is not out of the woods yet.

If you do decide you want exposure to the municipal marketplace, then know exactly how the municipal bond market is structured and pay close attention to the news of what is happening on a state and national level and compare.  There could be more credit risk problems in the future, although municipal bankruptcies historically remain rare. 

An exchange traded fund approach may be the way to go for investors who still want to have exposure and... right now... are able to get the tax benefit and bond diversification.  Keep in mind that a number of ETFs are focused on California bonds. 

One example to consider is a high-yield muni bond fund like Market Vectors High Yield Muni ETF (NYSE: HYD).  It is an ETF that replicates the price and yield performance of the Barclays Capital Municipal Custom High Yield Composite Index.  This low-turnover fund offers exposure to more than 200 higher-yielding municipal bonds across the country.  Its yield stands at 5.4%, and its operating fund expense is .35%. 

Here are the tax advantages:

Tax equivalent yield:

15% tax rate -- 6.29%
25% tax rate -- 7.13%
28% tax rate -- 7.42%
33% tax rate -- 7.98%
35% tax rate -- 8.22%

An apocalypse, by definition, is an event involving damage on a catastrophic scale.  There are definitely problems, like in California. 

Still, it remains to be seen how many more bankruptcies may erupt there or in other parts of the United States.  Right now, for investors seeking a higher yield and wanting favorable tax treatment, look for an exchange traded fund with shorter maturities and less exposure to fiscally stressed states.