Muni Bonds: Default Fears May Be Overblown

Tom Kozlik, a municipal bond analyst for Philadelphia brokerage Janney Montgomery Scott, sent clients a note on Jan. 14 reminding them of Warren Buffett's advice for navigating market turmoil: Be greedy when others are fearful. There's been plenty of fear in the $2.9 trillion U.S. state and local government bond market, typically a safe haven for individuals seeking tax-free returns and little risk of default. With states facing budget deficits estimated at as much as $140 billion and cities reeling from tax revenue lost during the housing market bust, some are calling that safety into doubt.

Meredith Whitney, the banking analyst who won fame for predicting that Citigroup (C) would be forced to cut its dividend in 2008, says she expects as many as 100 municipal defaults this year, adding up to "hundreds of billions" in debt. On Jan. 11, Edmund F. Kelly, chief executive officer of insurer Liberty Mutual, said his firm has cut its holdings of municipal debt in Connecticut, California, and Illinois, three states that are heavily indebted and strapped for cash, saying the market was being propped up by the belief that Washington will bail out local governments. JPMorgan Chase (JPM) CEO Jamie Dimon, speaking at a health-care conference on Jan. 11, warned of municipal bankruptcies on the horizon, cautioning investors in the market to be "very, very careful."

Investors pulled money from mutual funds that buy municipal securities for nine straight weeks through Jan. 12. Those withdrawals helped drive returns on muni bonds down 4.5 percent during the final three months of 2010, the worst quarterly return since the beginning of 1994, according to Bank of America Merrill Lynch's (BAC) index. This year the slide is continuing. The average muni yield, which moves in the opposite direction of price, jumped to 5.39 percent last week, the highest since the depths of the financial crisis in December 2008. When the New Jersey Economic Development Authority tapped the market on Jan. 13, the size of the deal was cut back by nearly half the original offer because of the high interest rates muni investors were demanding. That same day, Governor Chris Christie warned that health-care costs for workers threatened to "bankrupt" the state.

Christopher J. Mier, municipal bond strategist for Chicago investment bank Loop Capital Markets, says muni bond investors have been rattled by their losses and are shifting money back to the stock market, where prices have been rising as the economy stabilizes. "You've got a big asset reallocation going on here," he says.

Bill Gross, who manages Pimco Total Return (PTTRX), the world's biggest mutual fund, told Bloomberg Television on Jan. 12 that he doubted there will be many municipal bankruptcies. Christopher Hoene, director of research at the National League of Cities in Washington, says only four cities and counties have defaulted since 1970. "The overwhelming preponderance of local governments respond by cutting spending or raising other revenues, not by defaulting on debt," he says. "The bottom line is that sky-is-falling reports about the muni market are lacking in evidence."

There are some signs that municipal finances are beginning to mend. State and local government tax revenue rose 5.2 percent during the third quarter, according to the U.S. Census Bureau, marking the fourth consecutive increase. Deutsche Bank's (DB) analysts wrote on Jan. 14 that spending by U.S. states and localities during the third quarter point to a turnaround. And in Illinois, one of the states where the fiscal crisis has been most pronounced, Governor Pat Quinn signed a bill on Jan. 13 raising the state income tax rate to 5 percent—a 67 percent jump. On Jan. 10, California Governor Jerry Brown submitted an $84.6 billion budget that cuts spending by $12.5 billion.

Not all of the price declines hitting muni bonds stem from worries about defaults. In December, Congress and President Barack Obama agreed to extend all the Bush-era income tax cuts. Lower tax rates reduce the allure of tax-free bonds. Washington also allowed the Build America Bond program—which lavished subsidies on localities that sold taxable bonds—to lapse at the beginning of this year. With the subsidies no longer available, local officials will need to turn to the traditional municipal market, potentially increasing the supply of bonds. JPMorgan analysts estimate tax-exempt sales could jump to $325 billion this year, from $285 billion in 2010. "That's going to put pressure on the market for sure," says Chris Holmes, an analyst with JPMorgan.

The rout may prove to be a buying opportunity for intrepid investors, according to some analysts. "We have to say, here and now, that a generic long-dated AAA-rated muni yielding just over 5 percent is pretty juicy," wrote David Rosenberg, chief economist at investment firm Gluskin Sheff + Associates, in a Jan. 14 note. The yield on a top-rated, 30-year tax-exempt bond, now 5.2 percent, is the equivalent of 8 percent for a buyer in the top 35 percent tax bracket, according to Janney Montgomery. That's almost twice the yield on U.S. Treasuries. Says Janney's Kozlik: "Savvy municipal bond investors should be greedy when others are fearful, just as Warren Buffett advises, and scoop up bonds at bargain prices."

The bottom line: Fiscal distress has set off fears of defaults in the muni bond market. Some analysts see a buying opportunity for the brave.

    Before it's here, it's on the Bloomberg Terminal.