Muni bond investing is becoming a minefield

Municipal bonds have long been viewed as a staple asset class for conservative, income-seeking investors.

Munis are a large, liquid market of credit-rated securities that provide federal-tax-exempt income to millions of American investors. Towns, school districts and other public-sector authorities across the country have issued an estimated $3.7 trillion worth of these bonds.

But so far this year, three municipalities in California — Mammoth Lakes, San Bernardino and Stockton — have declared bankruptcy and are asking their bond investors to take reductions in the principal and interest payments that they are owed.

That club appears set to welcome another member. Atwater, a central California city with a population just under 30,000, this month declared a fiscal emergency and put itself on a path toward bankruptcy.

After the Atwater announcement, NBC News reported that one public-finance expert had described municipal bankruptcies in California as “spreading like a disease.”

According to recent reports from ratings agencies Fitch Ratings Ltd. and Moody's Investors Service, these recent bankruptcies may be just the beginning. They warn that after decades of steady performance, muni bonds — and by extension, muni bond funds — may see higher default rates and poorer performance.

If the economy continues to languish in the years ahead, muni bond holders may find themselves in a tight spot. Their financial claims increasingly may compete with the pension claims of retired municipal workers.

It is easy to envision a scenario in which “rich” bond investors are asked to take a haircut so that retired police officers, firefighters, teachers and other municipal employees can be made whole on their pension expectations. The brewing class warfare playing out in the presidential campaign may accelerate if the U.S. economic pie continues to shrink.

Given the uncertainty over issuers of domestic bonds, investors seeking income may want to consider assets in countries and sectors that offer stronger fundamentals.

The crunch in municipal finances is particularly troubling given the surge in muni bond investing over the past several years. In the wake of the stock market crash of 2008 — and the subsequent loss of faith in American economic resiliency — many investors appear to have sought the stability of munis.

In addition, as short-term interest rates are expected to remain near zero for years to come, and tax rates are expected to rise for wealthy investors, demand for these tax-free securities is likely to remain high. As a result, any hiccups in the muni market in the years ahead could have a significant effect on the investment world.

UNDER STRESS

In truth, municipalities all around the country — not just in California — already are experiencing stresses like never before.

Joshua Rauh, a professor at Northwestern University, recently estimated that unfunded pension liabilities are as high as $4.4 trillion, which is nearly $30,000 for every household in America.

Bear in mind, these unfunded liabilities are beyond the commonly discussed federal obligations of Social Security and Medicare.

Concerns about muni bonds aren't limited to academia.

Nearly two years ago, Meredith Whitney, who previously gained fame by making a bearish call on Citigroup Inc. stock, began warning of a “tidal wave” of defaults among municipalities.

She predicted that there would be between 50 and 100 major muni bond defaults. At least 42 occurred last year alone.

In a sign of just how high the stakes are, Ms. Whitney later was called to testify before Congress in regard to her prediction.

Bond insurers, which pay investors in the event that a municipality goes bankrupt, also have come under pressure. Shares of insurer MBIA Inc. (MBI) traded at more than $70 in 2006 but now languish below $12, with a price-earnings ratio of just 5.

Shares of its primary competitor, Assured Guaranty Ltd. (AGO), have fared little better, trading at just half their peak of 2007, also with a P/E of 5.

Clearly, equity investors are unconvinced that these companies have bright prospects.

In August, legendary investor Warren E. Buffett terminated certain contracts that his firm, Berkshire Hathaway Inc., made in the municipal debt market. As reported by The Wall Street Journal, under the contracts, Berkshire would have been required to make payments in the event of bond defaults.

By canceling these contracts, Berkshire is no longer on the hook.

It is clear that there are significant concerns about the health of the nation's muni bond market.

Of course, there is an alternative to default, though one that would be equally injurious to investors' portfolios. It isn't hard to imagine that if municipal finances got much worse, muni bonds could be bought by the Federal Reserve under its new perpetual quantitative-easing program.

Mr. Rauh has said that the municipalities could go to the U.S. Treasury for a bailout.

From there, it is just a hop, skip and a jump to the Fed's announcing the addition of muni bonds to its list of assets that it intends to buy. Muni investors would then be made whole, but at the cost of more inflation, which would surreptitiously reduce the real value of their portfolios.

Investors would be well-advised to review their holdings of muni bonds and determine whether their portfolios face heightened risk. Wise investors seeking reliable income should look to diversify their asset allocations.