Municipal Bonds: Was Meredith Whitney Right?

Last Updated May 12, 2011 10:01 AM EDT

(To see why investors in the highest-grade municipal bonds shouldn't be as concerned about municipal bond defaults, see the post "Municipal Bonds: Why We Likely Won't See Armageddon.")
Meredith Whitney caused quite a stir in December when she predicted "between 50 and 100 'significant' municipal bond defaults in 2011, totaling 'hundreds of billions' of dollars." So far, Whitney has been pretty far off the mark, and it seems to have had a large and unnecessary impact on investor behavior.

Her comments were among the triggers that caused investors to withdraw money from municipal bond funds for 24 consecutive weeks. Given the huge amount of outflows that might have been triggered by Whitney's forecast, I thought it would be worthwhile doing a check on how her forecast has turned out. As George Spritzer of Seeking Alpha noted, we should be seeing more than $4 billion of municipal bond defaults per week, according to Whitney. Yet, municipal bond defaults actually declined dramatically in the first quarter of 2011 compared with last year. Only nine small issues have failed, totaling $0.25 billion compared to about $1 billion last year, and none of the nine issues had an S&P rating.

It's also important to remember that defaults don't necessarily turn into losses for municipal bond holders, as recovery rates are much higher than they are for corporate bonds. Consider the Vallejo, Calif. bond default. It appears likely that the bond holders likely won't experience any loss of principal. And recall that in the case of two famous defaults, New York City and Orange County, bond holders were made whole.

The massive scale of problems that Ms. Whitney had anticipated haven't (so far) appeared because governments have taken actions to address the problem, cutting spending and raising revenues. Unlike the federal government, all states except one are required to balance their budgets. As a result, budget gaps are being closed by layoffs of public employees, greatly reduced services and increased taxes and fees.
  • More than 30 states have raised taxes
  • 31 states have reduced health care services
  • 29 states have reduced services to the elderly and disabled
  • 34 states have reduced funding for K-12 education
  • 43 states have reduced funding for higher education
  • 44 states have made cuts affecting their state work force
The result is that:
  • FY 2009: $80 billion of gaps closed
  • FY 2010: $120 billion of gaps closed
  • FY 2011: $100 billion of gaps closed
  • FY 2012: $140 billion of gaps to close
In his Seeking Alpha article, Spritzer also noted that there were several ways the municipal bond market has been addressing its problems:
  • The closing of budget gaps and the reluctance of the public to approve new debt issuance has meant that new bond issuance has shrunk dramatically. The first quarter saw the lowest quarterly issuance volume in more than 10 years. Some analysts expect total new issuance in 2011 to be less than half of 2010.
  • The lower bond issuance last quarter is a reaction to the especially heavy issuance in the fourth quarter of 2010 when the Build America Bonds program expired.
  • State and local governments have also been cutting back on non-essential capital projects and have much improved their fiscal discipline.
  • State and municipal revenues have also been improving.
And the political environment has enabled politicians to take a tougher stance in negotiations on wages, and especially benefits, with politically powerful unions.

More on MoneyWatch:
Municipal Bonds: Why We Likely Won't See Armageddon Why Buying Money-Losing Investments Can Be a Good Strategy Gold and Silver, What Goes Up... What the End of the American Age Means for Your Portfolio How to Create and Live a Fulfilling Retirement
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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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