It's true that many states and municipalities are under significant budgetary stress, thanks to significantly lower tax revenues and ever growing pension and healthcare expenditures among other items. However, very few general obligation issuers have defaulted so far. (Historically, the number of general obligation defaults has been infinitesimal relative to the number of defaults on corporate bonds over that same period of time.) In most cases, municipalities are cutting expenses to shore up their budgets. It's also worth noting that debt service is generally a relatively small fraction of overall expenditures -- usually in the neighborhood of 7 percent or less for high-quality issuers. So the problem that municipalities are facing isn't so much a debt problem as a problem that other expenditures are high relative to revenues.
To put some numbers on the analysis, a one-year Aaa-rated municipal bond is currently yielding around 0.5 percent. If your marginal federal tax rate is 35 percent, the tax-equivalent yield on the bond is about 0.75 percent. This compares to a current yield of roughly 0.25 percent on a one-year Treasury bill. Keeping in mind that not one issuer who started out rated Aaa defaulted from 1970 through 2009, you would need to believe that the probability of default over the next year on your portfolio of municipal bonds was 0.33 percent to break even between relative to the investment in one-year maturity Treasury bills. This may not sound like a very high default rate, but it is when you consider that the historical default rate is zero percent on Aaa-rated municipal bonds. (It's also important to note that this assumes that any bonds that default suffer a complete loss in value, which drastically overstates the historical loss suffered on investment-grade municipal bonds that have defaulted.)
The fear regarding near-term widespread default on high quality municipal bonds is being blown out of proportion by the financial media. High-quality, short-to-intermediate term municipal bonds continue to have an important place in the portfolios of investors who need to place fixed income in taxable accounts and are in high marginal federal tax brackets. You should also consider limiting your holdings to Aaa- and Aa-rated municipal bonds and avoiding sectors (regardless of ratings) with poor records of default -- such as health care, private activity and multifamily housing.
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