2/23/08

Are Municipal Bonds Safe?

Update 1/31/09: I think the below is still valid, but munis are where Obama's investment. They have become a lot safer.

Previous post:

Since more and more people seem to be wondering whether municipal bonds are safe, I thought I would update this post, which I wrote in February. Despite Money and Morningstar (we can add USA Today to the list) urging people to head for the "safety" of municipal bonds earlier this year, I didn't think they were safe. Unfortunately, it looks like I was correct.

Now the Wall Street Journal is recommending munis. I think they're wrong.

Forget about the tax free yield. Yes, it's high. But there's a reason. Investors are taking their money out of muni funds because the current yield is not enough to compensate for the risk, which comes in two forms.

First, municipal bond funds, faced with redemptions, end up selling their assets for lower prices than they could have gotten in a more orderly sale. This lowers the price of muni bonds in general, so municipalities end up having to pay a higher interest rate than they might otherwise under better conditions.

Second, the default risk is higher. Funds that were considered low risk a year ago are now considered high risk.

The WSJ says municipal defaults are rare. I won't argue with that. But if there is a perceived danger of default (this will certainly rise as the economy worsens) municipal bond funds will fall in value. And while defaults are rare, they do happen. New York City defaulted in 1975. Cleveland defaulted in 1978. In 1873, during severe economic turmoil that some analysts are saying is most closely analogous to our current situation, around 24% of all outstanding municipal debt was in default.

Here are reasons to think municipal bond prices will continue to fall. Cities, townships, and states get their revenues in three basic ways: income taxes, sales taxes, and property taxes.

  1. People are losing their jobs, and those being hired are settling for lower wages. That means less tax revenue from income taxes.
  2. With the credit lines turned off and jobs less available, consumers are spending less. That means less sales tax revenue. It also means less jobs, which takes us back to 1.
  3. Property values are continuing their plunge, and foreclosures are mounting. That means less property tax revenues.

This is commonsense, but there's empirical evidence. According to a study by Enhance Reinsurance Co. in 1988, "municipal defaults usually follow downswings in business cycles." One may argue that things have changed since 1988. They have--for the worse.

It's true that municipalities can raise taxes, but this can only go so far. Moreover, tax raises often curb economic activity, which only weakens the tax base. And since cities and states can't print money, there's really nothing to be done once their coffers are empty.

As mentioned in the original post, municipal borrowing is becoming costlier. In late September 2008, the seven-day borrowing rate increased over three times in one week.

If you still want to buy muni bonds, I urge you to consider their holdings very carefully. Try to pick the ones with the most stable tax base. The higher the yield, the higher the risk. Don't rely too much on credit ratings. They're made by the same companies (Moody's, Fitch, etc) that rated securitized subprime mortgages AAA.

Financial newspapers and magazines always need something to write about. They'll keep repeating the message that municipal bonds are safe investments. Eventually this will prove true. How much money you'll lose between now and then will be another story.

You want safety? Buy short term treasuries. Their yields are low because that's where the safety is.

Updated: October 6, 2008.

Original post from February 2008 follows (note that some of the links, such as those directed toward Yahoo! finance are no longer working).
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Some financial publications and newsletters, including Money, and Morningstar have recently started recommending Municipal Bonds, touting their safety and noting that depending on one's tax bracket, their yields are higher than those of federal bonds. The yield, after tax savings, is indeed better than what you can get on federal debt. The safety, however, I'm not so sure about.

Municipalities issue debt to pay for various things, like road repairs, public transportation, education, etc. They pay the debt mostly out of the tax dollars they receive from property taxes, sales taxes, and use taxes. All bond issuers are given ratings, and this includes municipalities. To sell their municipal bonds, townships, school districts, etc, need top ratings, like AAA or AA.

Many municipal bonds are sold as put bond derivatives, in which investors can tender the bonds back to the municipalities at face value if some condition triggers. One such condition is a credit rating downgrade, say from AAA to B. If a bunch of municipal credit ratings are downgraded, investors, such as money market managers and pension funds, who can only hold the highest quality debt, will start tendering the bonds back, and the municipalities will have to pay for them. A number of not so good things will result.

The muni bond market could freeze up, like this one which is starting to. If cities and towns don't have enough money to cover the put bonds, they may default, or may be forced to issue new debt at higher interest rates--all while the economy is slowing and their tax base is shrinking. Townships are already experiencing financial difficulties. One way they're shoring up funds is by over assessing property values. While housing prices continue their fall as the bubble deflates, property taxes continue to rise. One can fight city hall on this issue, but if enough people do, Money quotes one assessor, "the tax rate would just have to go up."

That is, townships' balance sheets are already stretched. If they have to buy back old debt and/or have trouble issuing new debt, muni bond prices will tumble, making them not very good--or safe--investments.

But why would munis have their credit ratings lowered? Townships get their credit ratings by buying wrap guaranties from bond insurers, like Ambac Financial (ABK), MBIA (MBI), and PMI (PMI). They pay the bond insurers a premium, and in return get the bond insurers' credit ratings. Unfortunately for the munis, the bond insurers have been up to no good recently, insuring junk like subprime mortgages way above the value of their assets. I wrote about it in January about why financial stocks should head lower.

There is a real danger that the bond insurers will have their credit ratings downgraded. If that happens, many municipal bond ratings will also be downgraded, and what's mentioned above will start to occur.

There are indications that the municipal bond market is already starting to freeze up. Recently, some large public borrowers, like the Port Authority of NY and NJ, were unable to sell most of their bonds. A low risk borrower like the University of Pittsburgh Medical Center saw its interest rates climbing from 3.5% to as high as 17%. Market makers for munis like Citibank, with their own balance sheets in trouble, are not buying the bonds either. Municipal bonds are turning toxic. More on this here.

There are talks of breaking the bond insurers up, with one half keeping all the good debt, like munis. Additionally, Warren Buffett has ventured into insuring and reinsuring municipal debt. Finally, the stock market went up in the last minutes of trading on this past Friday because of a rumor that the banks are working on a deal to bailout the bond insurers. More on that here.

Perhaps any of these things, or their combination, will make municipal bonds safer. But until then, they're not very safe.