How Muni Bond 'Molotov Cocktail' Could Do Big Damage
For now, states are considering more spending cuts and tax hikes and tapping their rainy-day funds again. For investors in municipal bonds, meanwhile, there are other troubles to think about.
Half of municipal bonds are in mutual funds that buy and sell constantly. This means even if defaults remain low, investors can lose money if their fund managers overreact to the fear that defaults will rise.
Those who prefer to own individual bonds instead of investing in funds face risks, too. Many munis owned directly are barely traded, so sellers sometimes can find few or no buyers.
That's not the case with U.S. Treasury bonds or stocks of big companies like General Electric or Microsoft, which enjoy liquid markets and the services of deep-pocketed firms charged by regulators with buying if no one else will. Muni sellers are basically on their own, and prices can fall fast. (Note: General Electric is the parent company of CNBC.)
In 2008, investors pulled $15 billion out of muni funds in four months while prices were tumbling. To raise cash for investors wanting their money back, fund managers had to sell munis even if they didn't want to. The average fund lost 5.5 percent, according to Morningstar. In 1994, a similar cycle sent bond prices down, too. The average muni fund lost 5.8 percent.
Something similar is happening now. In the two weeks that ended Nov. 24, investors pulled $7.8 billion more from muni funds than they put in, according to the Investment Company Institute. That helped push some mutual funds down 10 percent. It was a big change: For much of the past decade, investors were pouring money into munis, not taking it out.
"When people redeem, I have to sell," says Thomas Metzold, who manages Eaton Vance's National Municipal Income Fund. It's down 5.4 percent in a month. "What can I do?"
Despite the turmoil, Metzold dismisses the idea of munis as the source of the next systemic crisis. He thinks the worst has passed and notes bond prices have inched back up in recent days. He thinks the selling reflected not fear of defaults but an oversupply of new bond issues, which overwhelmed demand.
Other investors say that because there are tens of thousands of bond issues of various credit quality and with various dates on which they mature, it is difficult to say whether the market as a whole is overpriced.
And even if a town or city gets into trouble, muni experts say, it will do almost anything to avoid reneging on its debt. "Municipalities run on debt, and if they default and can't borrow, things will grind to a halt," says James Klotz, president of muni broker FMS Bonds. "They can't allow themselves to get shut out of the market."
Still, some of the biggest names on Wall Street warned in the past year that the market was primed to fall. They include James Chanos, who bet against Enron before it collapsed, billionaire Warren Buffett and Meredith Whitney, a banking analyst who predicted that industry's crisis.
Municipalities use revenue from taxes, fees and other sources to make interest payments and repay principal when a bond matures. Muni bonds are attractive to investors because you don't have to pay federal income tax on the interest. That's not true for corporate bonds. So while top-rated munis maturing in 10 years yield 3.38 percent annually now, that's more like 5.2 percent for those in the highest tax bracket. If you buy bonds issued in your state, you often don't have to pay state or local income taxes, either.
Investors tend to buy munis based on the yield and take their chances that the price of their bonds or the price of their muni fund shares won't fall. Despite the recent drops, bond prices are still up this year. That rise plus interest payments translates into 5.5 percent gain for munis so far this year, according to Barclay's Capital.
The bullish case for munis is that they almost always make good on their payments. Only 54 of the 60,000 munis that Moody's Investors Service rated from 1970 through last year have defaulted. But history may not be a good indicator because the finances of local governments are in their worst shape since the Depression.
"Risk is inherent in the unprecedented, not the precedented," Aronstein says.