Subscribe to this BlogWill California's budget crisis whack your munis?
The safety of municipal bonds is often taken for granted. After all, the theory goes, if a state or city runs short on cash, it can always tax the heck out of its constituents to make up the shortfall. Corporations, on the other hand, don't have that kind of fallback.
But California's recent budget troubles have thrown the default possibility back into the limelight. And that might have you wondering if you should bail out before yet another theoretically safe investment proves to be not so secure after all.
If you haven't been paying attention, California seems to keep getting closer and closer to default, and its government can't decide how to clean up the mess. Fitch Ratings recently downgraded the state's bonds to the worst in the country (which happens to be A-, a rating many corporations would kill for). While the spokesman for California's Treasury department says a default "won't happen," could you ever imagine a Treasury spokesman saying default was "kind of a possibility"?
"I'll be bankrupt"?
Let's start off this discussion with what should be your central question: "What do I have to lose?"
In the case of muni bonds, the answer is "Not much." For one, single-A rated municipal bonds have a historical default rate of 0.0084%. That is, only about 1 in 12,000 defaults over a 10-year period.
But let's say you hit that unlucky jackpot. Your state says, "To heck with our creditors. We don't care if we won't be able to borrow money again for years," and refuses to pay. Then what do you have to lose? The answer still is, "Not much." In fact, according to the Wall Street Journal, in the Great Depression, while more than 15% of muni bonds defaulted, the estimated loss rate for investors was 0.5%. When Orange County, Calif. defaulted in 1994, investors actually got all of their money back.
And here's what you have to gain: Right now, 5-year muni bonds are yielding 2.14%, which is the same as 2.97% if your income is taxed at 28%. That's compared to a 2.44% yield on 5-year Treasury bonds.
Let's say you're weighing the purchase of a 5-year muni bond in its typical, $5,000 denomination against the purchase of a risk-free Treasury bond. Are you willing to risk a 1 in 12,000 possibility that you lose $25 (0.5% of $5,000) for the 11,999 in 12,000 chances of making an extra $125 over 5 years?
For me, the answer is yes. But if the 0.0084% chance of a $25 loss from a default frightens you, buy a municipal bond mutual fund that can mitigate your risk even more, such as the Fidelity Intermediate Municipal Income fund (FLTMX). Mutual funds will have other risks attached. If interest rates rise, fund prices can fall, causing you a larger loss. But in exchange, you'll lose little money even if one of the fund's bonds is completely wiped out.
Now, you could argue that there are even greater opportunities in stocks and corporate bonds, since virtually risk-free assets like Treasuries and municipal bonds aren't offering much income right now. That aside, muni bonds still look like a better bet next to those issued by the U.S.A.
This article assumes one thing that the Federal government won’t step in and treat California Muni Bonds like it treated Corporate Bonds from GM. Just imagine getting back 28% of your investment?
Are Muni Bonds Financial Narcotics ?
There is growing acknowledgment amongst some muni bond analysts that downgrade risk has increased substantially and therefore significant investor risk of mark to market devaluation may occur. Investors should forget about liquidity when their municipal bond issue goes downhill….unless they are prepared to take a big capital loss …..
It is astonishing that muni investors are “blocked” about downgrade risk. Some think of munis as commodities like U.S. Treasuries, but they are not.. A municipal bond is a loan to a municipality or agency which have about as much liquidity as a commercial loan. This is troubling and the way the muni complex works is no different than any other structured or derivative product: no transparency. I see investors ignoring the significance of rapidly declining municipalities' tax receipts, the Federal intervention of propping municipalities up with fangled inventions ( Buy America Bonds) . There is only one reason that California got away with excellent pricing a few months ago on its huge deal: this is a closed information market. States like New are equally in trouble ………no one talks about what is happening financially to New York State and New York City. Are muni analysts missing something? In the Corporate bond market, increased default or downgrade expectations are matched with increased borrower cost. Munis will not remain immune to this market phenomena . Check these two reports and you will see what is the status of municipalities' ability to pay back investors.
and:
http://www.nasbo.org/Publications/PDFs/FSSpring2009.pdf
Munis are high in their own stratosphere right now as a credit product. They should be compared to medium to low investment grade and to even below investment grade loans. The only time they came close to reflecting their true underlying credit reality was in Q4 2008.
So when the Rockefeller Inst. of Govt. says "sales tax in late 2008 was worst in 50 years" no one pays attention. No one should be told that muni rates have gone down because muni credit risk is declining. A shoe is going to drop in the muni market and when it does to it’s going to hurt awful….. When the financial press tells people that investors are "gobbling up" munis I say watch out!
Imagine the perfect product, almost the whole world is in financial turmoil and there is this product called municipal bonds that you don’t have to pay taxes on, you don’t have to worry about default because its negligible, don't fret about liquidity even if your bonds get downgraded because you got a 7-10 % effective yield and that beats DOW and S&P hand over foot. You just make money and don't even bother to look. Muni bonds become the new financial narcotics.
There's no shortage of fearmongers on this blog. Here's a quote for you doom sayers out there from last week's news:
In the secondary municipal market, California bonds due in 10 to 30 years were trading more strongly yesterday because the market has priced in expectations for a missed budget deadline, said Domenic Vonella, an analyst with Municipal Market Data.
"Not having a budget on time has been par for the course lately," added Parker Colvin, head of municipal securities trading at Stone & Youngberg in San Francisco.
Perhaps muni bonds will not default but when interest rates rise as a result of the Federal Deficit and muni rates rise in tandem with U.S. Treasury bond rates and muni bond rates hit over 6.5 % and you have to sell your current 5% coupon muni bond when muni rates reach their peak are you prepared to loose 25% or more in your principal? Let's see 25% of
$ 50,000.00 is $ 12,500.00. Is that enough to loose?
You leave one thing out in your analysis, and that is inflation. And I'm not talking about the biased and manipulated CPI fantasy numbers that the government announces. Those that track the true rate of inflation put it at around 2% (see: shadowstats.com), meaning that your 2.14% muni is actually yielding a whopping 0.14%. Hardly worth the effort when you can get 12%+ from a Canadian Royalty Trust. Give me a break.
Get your money out fast there is little time left before California defaults.
We are in a different situation than any time before, even during the Depression.
The U.S. is going to default too. People are still to comprehend the size of our debt, and the unfunded obligations it is unpayable.
Deep cuts WILL happen, and they should start with the over compensation in Pensions for State Employees. These people are living on another planet, with no hope of an Earth re-entry. Once again the fault does not rest with our Govenor, but our State lawmakers.
California's Governor refuses to sign a budget that uses accounting tricks and impossible math to close the gap. He's taking a lot of flack for that but he is right on with the point. The time for temporary fake fixes is long past.
Yet, the same Governor wants to use yet more borrowing to help close the gap. The time for that is long gone too.
The Dems want to add more taxes. Always an "easy" fix from the point of view of a politician, but California is probably past the tipping point of diminishing returns on additional taxes. So the time for that is also past.
Deep cuts is the only option California has. Something that the citizens are going to have to come to grips with. Like it or not.
Which, they wont. Like it, that is.
There will be painful cutbacks statewide combined with a bailout effort–yet unannounced–from the federal government. (Too many votes at stake to just ignore.) Hopefully this will motivate California to turn over a new leaf and become more thrifty and efficient. There's bloat in the budget.
The article here seems to understate the risks to specific California municipal bonds. Further downgrades could force funds to sell bonds en masse, triggering a significant and sudden drop in value. I've met people here who bought 'high-yield' municipals with coupons as high as 14%. (These are the same types of investors who were big into JDS Uniphase during the .com bubble.) This type of 'bargain' now looks mighty risky.
At least things aren't boring here in California!
California has become populated by fruits and nuts with far left socialist ideals. Almost none of them were born here or grew up here.
I was born and raised here. We used to have good solid people in government with sound ideas and policies. Now we have Mark Leno on the news every day.
Screw it! The fruits and nuts can have it. I am leaving next year and going to Texas or Georgia. BTW, Texas has a surplus not a deficit. Do the research right here on this site.
Mr. Redwood City (of the very liberal Bay Area) blames the mess on the governator while Democratic party hacks who wouldn't know an honestly earned dollar from a gov't hand-out have run the Not-So-Golden-State into the ground.
As an "ex-patriot" (and very productive) Californian who, with my family, voted with our feet to flee the silly air they all breathe there three years ago, it makes me sick to see how unrestrained silly spending and general liberal goofiness has ruined the once great state.
California is ground zero for the ultimate failure of the unrestrained welfare state. LOL
You're using long-term statistics to come up with a probability that is not reflective of what is happening today. My advice is to do what allows you to sleep at night based upon the unprecedented (in our lifetime) economic meltdown and the extremely high probability of California defaulting.
You're dreaming. Using the default rates of the last 10 (bubble) years to forecast future default rate is nonsense. The odds of a CA default are now very high, maybe as high as 50/50. The state has a Republican governator (Herbert Hoover was a Republican, too), who is fiddling while the state burns. The state will begin issuing 'IOUs', which sound to me like the state printing money.
While CA has the largest annual budget deficit of any state ($27 billion), there are a number of states that have even higher % budget deficits (NV, NY, TX, etc. are above 30% shortfalls). So, this is a widespread problem.
Even if you feel lucky, you should sell half of your muni bonds. 2% interest is not enough to compensate for the risk of loss of principal. Only very wealthy investors should take this level of risk for such low rates of return.
This article exhibits some of the same thinking that led investors to buy Chrysler bonds in 2007 and 2008. The thinking was that there was not much downside risk.
What investors did not count on was a Federal government takeover and being told to take even less for their investment.
The same thing might happen to California GO Bonds and the bonds of other Munis from that State. There might be a Federal Bailout of California with the Feds dictating to bondholders that they take 50 cents on the dollar. The justification would be a "National Emergency". This might violate several laws but I would not put it past this Administration.
Also any owner of Cal. Muni bonds who insists on being paid in full will be labeled as greedy. I think the risk of Cal Muni bonds is greater than many investors perceive. Best to stay away unti the dust clears