The fiscal problems here in California and other states have been making headlines the last few months causing uncharacteristically high levels of volatility in the municipal bond market. This volatility has sent muni prices down and has led to sizable outflows from muni bond funds and ETFs. Many investors are wondering if they should be concerned about all the negative press and turmoil in the muni markets. In my opinion, the current muni headlines may mask opportunities for long term investors.
Muni bonds remain a relatively safe way to invest and earn tax-free income. The recent sell-off has led to some very attractive yields going forward. Yes, state and local budgets shortfalls are not going to be solved overnight. However, investors should note that fiscal conditions appear to be getting better. Tax revenues for state and local governments showed steady improvement in 2010. In fact, state and local governments have been running a surplus for the past 4 quarters, primarily due to increased tax receipts.1 States are also being forced to make meaningful budget cuts. These cuts in services may not be pleasant to us as residents, yet they should provide comfort as muni bond investors as it provides evidence that state and local governments are going to do what it takes to stay solvent and meet their debt obligations.
Municipal issuers also have the power to raise taxes and fees to balance budgets and that is exactly what is happening. The state of Illinois, often lumped in with California as one of the states in the direst shape, recently took a major step to solving their budget problems. They raised income taxes from 3% to 5% and increasing corporate rates from 4.8% to 7%.2
Claims of record municipal defaults for 2011 seem farfetched when viewed from a historical perspective. According to Moody’s Investors Service the average default rate for investment-grade muni bonds is 0.03%. This is much, much lower than for similarly rated corporate bonds. The one-year record for municipal defaults was $8.5 billion in 2008 and has declined to $7.3 billion in 2009 and $2.8 billion in 2010. These may seem like large numbers but represent a very small level of the $2.9 trillion muni market.2
Headline risk will continue to be a factor in the muni market. Ongoing budget problems will continue to dominate the news and be a concern to investors. However, muni bonds are at historically cheap levels versus corporate bonds.2 The municipal bond market is essential to state and local governments to fund a variety of projects like schools, bridges, roads and hospitals. These entities can simply not afford to alienate muni bond investors and bite the hand that feeds them. Currently the muni market is being dominated by fear, but fear can lead to opportunity. Warren Buffett put it best when he said, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
1. J.P. Morgan, Market Insights, Weekly Market Recap, 1-24-2011
2. Invesco, Investment Insights, Comments on Recent Municipal Market Volatility, 1-2011
Damien helps individuals invest and manage risk. He is a CERTIFIED FINANCIAL PLANNER™ professional and a principal of Walnut Creek Wealth Management. These are the views of Damien Couture, CFP® and should not be construed as investment advice. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. Your comments are welcome. Damien can be reached at 925-280-1800 x101 or Damien@WalnutCreekWealth.com.
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