Muni Bonds - Meltdown or Overblown?

Last Sunday, CBS 60 Minutes ran a startling and rather depressing segment on State and Municipal government financial deficits. And what made it depressing was the implication that muni bonds would usher in the next financial crisis. Wall Street Analyst, Meredith Whitney, predicted 50 sizable defaults in 2011, and that the default dollar amount will be in the hundreds of billions.

Whitney's logic for the meltdown is that State and City governments are running huge deficits today with Federal stimulus. When that stimulus ends later in 2011, the massive defaults will begin.

MoneyWatch columnist, Larry Swedroe, takes a different view noting the media has blown the risk out of proportion. Swedroe noted that, during the great depression, the loss on muni bonds was only 0.5 percent.

The three risks of Muni Bonds
My view on muni bonds has been consistent. They are risky. Here are the three risks muni bonds present, followed by my advice on how to invest in these instruments.

Risk #1: Default risk - Unlike the US Government, municipalities cannot print money. They can and do default. How likely they are to default in the future is a matter of debate, but I don't know how accurate or relevant any data from the great depression is likely to be. Though the great depression is certainly one data point, I wouldn't count on the next financial crisis looking anything like the last great depression.

Risk #2: Liquidity risk - There are very large costs involved in trading individual muni bonds, as I noted in Municipal Bonds and the Industry's Dirty Little Secret. Considering how huge the bid-ask spreads usually are on this very illiquid market, they can cost three to five percentage points to trade. Swedroe stated his firm can trade with very small spreads, though I suspect he was only looking at part of the transaction before it was sold to the next investor. I examined some of the total spreads in Muni Bonds Costs - The Whole Truth. Buying bond funds eliminates liquidity risk as they can be sold at net asset value.

Muni bonds became especially illiquid during the height of the financial crisis, and even the one 60 Minutes segment could cause spreads to increase. If Whitney is right about the number of defaults, I'd expect markets to become even more illiquid.

Risk #3: Interest rate risk - All bonds have interest rate risk and the longer the terms of the bonds, the greater the risk. For example, should interest rates increase by two percent, a bond with a ten year duration would decline in value by approximately 20 percent. The argument of holding the bond to maturity will eliminate this interest rate risk is a myth.

My advice on Muni Bonds
If you are in a tax bracket that provides significantly greater after-tax yields than taxable equivalent bonds, then munis may have a place in your portfolio. Just keep these three things in mind to manage the risks mentioned above.

Don't put all of your eggs in one basket: Muni bonds represent roughly eight percent of the total US bond market, which is dominated by Federally-backed bonds. My advice is to make sure your bond portfolio is also dominated by US Government-backed debt. Only the US Government can print money.

Stay short to intermediate term: With all of the money we are printing, the risk of inflation is high. Long-term bonds, whether muni or some other type, will get creamed if we do hit high inflation.

Buy your bonds in low cost funds: Never buy individual bonds. You merely accept more default risk from lack of diversification, and liquidity risk from potential trades. Buy ultra low cost muni bond funds with hundreds of holdings such as those from Vanguard.

My advice is not to bet too heavily on either extreme. I'm not convinced that munis are so low risk that I'd put a huge chunk of fixed income in this relatively small asset class. I also wouldn't dump all muni bond funds in a fire sale because of one compelling TV segment.

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Muni Bonds Costs - The Whole Truth
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