Muni Bonds: Tax Free Doesn't Mean Worry Free

Financial Sense ^ | 18 Dec 2010 | Kevin Brekke

[george76]

Prior to the 1930s, it was not legally possible for a U.S. municipality to declare bankruptcy as no legislation existed covering this event. The growing number of insolvent towns during the 1930s depression necessitated a change in the Bankruptcy Act.

The act was amended by Congress in 1934 to cover municipalities...

The majority of municipal bankruptcies are the result of two things, 1) economic problems, and 2) financial mismanagement by elected and/or appointed officials. No surprise here...

Chapter 9 bankruptcies are not designed to forgive debt. Rather, their intent is to aid a municipality through reorganization ...

There are two trends that I see underway here. The first concerns contagion; state governors are increasingly paranoid that a default by a municipality in their state will cause borrowing costs to rise for other cities as well as the state itself. With just about every state in the union battling a budget deficit, an increase in borrowing costs is an unwelcome visitor...

The second trend ... bailouts and money giveaways by federal governments and central banks... The endgame creeps closer.

[businessprofessor]

Rock meet hard place. If the problem was isolated to local governments, the problem would be manageable. The problem involves all levels of government with structural spending problems. The only solution is to rewrite the structural obligations at all levels of government. However, the structural spending problems have strong legal protections and voting constiuencies. Since voters will likely revolt about this approach, outside failure will be the only choice. External forces will eventually force radical change with tremendous hardship. We are not too big to fail. The rest of the world is planning on our failure.

[george76]

One of the reasons that gold, silver, oil, food stuffs, steel...are all way up in price.

[Alberta's Child]

Interesting post.

With municipal bonds, there is an added element that comes into play even aside from any of the specific financial considerations of the municipality in question. With Federal income tax rates lower now than they were even 15 years ago, the tax-exempt status of municipal bond interest doesn't have the same value as it did in the past. So bond holders have been accepting lower interest rates on these bonds in exchange for the tax-free interest . . . even as bond income has declined with falling interest rates, and lower income tax rates reduce the "value" of the tax-exempt income.

When you factor in the default risk that was previously considered highly unlikely, you end up in a position where municipal bonds may simply not be a very good investment unless you can buy them at a discount.