Munis offer no safe harbor
It has been an accepted fact for ages: Municipal bonds are a safe, secure, and conservative investment, a good foundation for anyone’s portfolio.
As the stock market roiled over the past few years, many investors pulled their money out of the market and stashed it in muni bonds for the time being. After all, the bonds are attractive because of the federal tax exemption and the fact that Standard and Poor’s says of the nearly 55,000 municipal bonds issued in the last 25 years, only 47 have defaulted. Moody’s, going back to 1970, pegs the number at 71, both just fractions of the overall $3.7 trillion muni market, especially when looking at the corporate default rate, which is as high as 40 percent over the same period.
But the New York Federal Reserve Bank is crushing that perception. The bank released a study it says shows the municipal bond default rate is nearly 40 times what S&P and Moody’s report. And with the uncertainty of the economy and potential budget cuts, especially should Mitt Romney and his slash-spending sidekick Paul Ryan win in November, investors may rethink sailing their boat into the muni safe harbor. The GOP plan for cutting spending includes closing the tax exemption for municipal bonds, a proposal that conservative outlets such as the Wall Street Journal think is a good idea, both to increase revenues and tamp down the urge by governments to borrow more than they can afford.
The wide disparity in the muni default numbers has to do with ratings. S&P and Moody’s only look at rated bonds, while the Fed study points out that many bond issuances by the public sector are not rated. According to the Fed database, going back to 1958, some 2,527 municipal bonds have gone into default, the largest portion – 28 percent – being industrial development bonds.
But revenue bonds for airports, toll roads, schools, ballparks, and such, are dependent on revenue streams that are fluid and they count for the vast majority of muni defaults. The New York Fed did not offer a detailed list of where and what bonds have defaulted so it’s hard to tell if any were from Massachusetts.
Why does this matter to anyone but big-time investors and banks? Because the Fed’s numbers show that nearly three-fourths of municipal bonds are held by households. Individuals account for just over half of muni investors, and mutual funds — where most people have their 401(k)s – account for another 25 percent of the market.
If the default rates increase and/or the tax exemption disappears, it will have a huge effect on small investors. The safe harbor is beginning to get a little choppy.
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