Tuesday, February 8, 2011

Are Munis Next?

If you are a municipal bond investor, you have done either one of two things. Believed the recent rhetoric about the imminent bankruptcy of numerous large American cities and with thosebankruptcies, a default on the municipal bonds they have issued or do not believe that this can happen.

Those that believe have been reported as selling their investments, divesting almost a third of what was invested in these securities since November of last year. This makes less knowledgeable investors skittish to say the least and worried - as all bond investors tend to be - that you will ve left holding what are essentially worthless securities.

Volatility has been seen in this market and if Vanguard's recent withdrawal from the muni ETF market is any indication, you might be right. But some logical evidence points to other reasons why this is overblown.

Many 30-year AAA tax-free bonds now yield over 5%. )These ratings are key to the quality of these bonds. Lower ratings mean higher yield offerings and with it, an outward indication that risk exists. But if you are in the top federal tax bracket, you’d have to earn almost 8% in a taxable bond to get that kind of after-tax yield. In this interest rate environment, that’s nothing to sniff at.

Plus, municipal bond issuance will drop to $350 billion this year from $430 billion last year. If you took Economics 101, you know that decreasing supply generally firms prices up.

The extension of the Bush era tax cuts do play a role as do the slumping US Treasury rates. Some experts, Bill Gross, the man who manages Pimco investments recently declared, “I don’t subscribe to the theory that there will be lots of municipal bankruptcies.”

Panic creates the illusion that there are bubbles in certain markets, municipal bond markets not excluded. Ignoring risks make people worry more than they should. The bottom line: there is volatility in every investment and the chance you will lose money. But municipal bonds will not default  en masse anytime soon. Unless of course, the economy fails to recover.

Paul Petillo is the Managing Editor of Target2025.com/BlueCollarDollar.com and a fellow Boomer

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