In yesterday’s column, I shared why Detroit’s bankruptcy filing could set a dangerous precedent.
The city is trying to force municipal bondholders to accept less-than-full repayment. And that’s never happened before – in 201 years.
As I explained, that’s not a streak we want to break.
Now, if that were the only danger facing municipal bond investors, I wouldn’t be so worried. Sadly, that’s not the case.
Right now, the municipal bond market is facing three other stiff headwinds…
~ Muni Bond Threat #1: Misguided political proposals
Currently, interest income earned on municipal bonds is exempt from federal taxation. But President Obama’s budget proposal in April called for limiting this exemption.
Given the enormity of the federal government’s budget deficit – and the current administration’s predilection for raising taxes – the muni bond exemption isn’t untouchable.
If it’s eliminated (in whole or in part), municipalities will be forced to pay higher interest rates to attract investors. And that’s not something they can afford to do (see threat #3).
~ Muni Bond Threat #2: Market forces
Forget the threat from government policies, though. The market is also conspiring against municipal bonds.
Much like Treasury bonds, municipal bond yields have been rising in anticipation of the Federal Reserve tapering its bond purchases. The higher yields rise, the higher borrowing costs get for municipalities on newly issued debt. Again, that’s something they can’t afford.
~ Muni Bond Threat #3: A less-than-robust recovery
While the U.S. economy isn’t teetering on the brink of another recession, it’s certainly not enjoying a robust recovery, either.
Believe it or not, some pundits are spinning a yarn about how the sluggish recovery isn’t impacting municipal finances. Like Bart Mosley, Co-President of Trident Municipal Research.
He says that Detroit’s $18.5-billion bankruptcy – and Jefferson County, Alabama’s $4-billion bankruptcy filing in 2011 – are actually “exceptions that prove the rule that state and local government credits are solid… [And they] highlight the extent to which state and local governments have been much more fiscally responsive” than the federal government during the crisis.
I hate to burst Mr. Mosley’s bubble, but the data tells an entirely different story.
According to the National League of Cities’ study of finances in American cities…
- General fund revenue fell for the sixth-straight year in 2012.
- Income tax and property tax collections are down for three straight years.
- And cash reserves are down 50% since 2007 – hitting the lowest level since 1996.
That’s hardly a picture of “solid” finances. Truth is, there are numerous municipalities in dire straits. So much so, that Moody’s has put 29 under review for possible credit downgrades, not upgrades, in April.
Three Toxic Markets
In terms of specific cities, I’d be most concerned about Chicago and Cincinnati. Much like Detroit, they’ve suffered a mass exodus of citizens.
Based on the last census, Chicago’s population checks in at 2,695,598 people, down 25% from its peak of 3,620,962 people in 1950. Meanwhile, Cincinnati’s population of 296,223 people has dropped 41% from its peak population of 503,998.
And overcoming financial obstacles becomes increasingly difficult when your tax base contracts.
What’s more, every major city in California is also on my watch list. Why? Because new accounting standards went into place this month, requiring municipalities to accurately report unfunded pension liabilities. Collectively, the changes could result in unfunded liabilities jumping from $128.3 billion to $328.6 billion, according to the California Public Policy Center.
The revelations could make cities like Los Angeles, San Francisco and San Jose severe credit risks. And if any of them declare bankruptcy? Well, investors in the largest muni bond ETF will get slaughtered.
As I pointed out yesterday, the iShares S&P National AMT-Free Muni Bond ETF (MUB) boasts virtually no exposure to Michigan. However, it’s grossly overweighted to California. Almost one-quarter of the fund’s $3.3 billion in assets are invested in muni bonds from the state.
In terms of profiting from such a turn of events, we don’t want to sell the ETF short. Otherwise, we’ll be responsible for covering the monthly dividend payments. But we could profit from a nasty selloff on the heels of another historic municipal bond default by purchasing some February 2014 $102 put options.
Bottom line: All it takes is a crisis of confidence to undermine a supposedly “safe” muni bond investment. And there are definitely enough headwinds in the market to bring one about. Caveat emptor!
Ahead of the tape,