Since the airing of a segment on “60 Minutes” last December in which Meredith Whitney predicted massive municipal bond defaults totaling hundreds of billions of dollars, the municipal bond market has been in disarray. For the period ending January 19, 2011, mutual funds which invest in municipal bonds witnessed net cash outflows for ten consecutive weeks totaling over $25 billion.
Given our significant exposure to this investment sector, we feel it is timely to respond to some of the negative commentary, reassess the investment risks, and evaluate how this negative sentiment might offer attractive opportunities for investors today.
Clearly, state and local governments are facing serious budget issues. A downturn in the national economy as well as the precipitous decline in housing values has put a large dent in state and local government revenues. Moreover, government employees’ pay and benefits have steadily grown. Until quite recently, the compensation issue went unnoticed by the taxpayers. On the bright side, perhaps the recent turmoil has served to “wake the sleeping giant”. Recent political battles in Wisconsin and Ohio have focused attention on municipal budget issues. Yes, the problems are very real, but let’s try to put this in perspective.
A number of factors mitigate the risk of municipal bond default. Debt service (principal and interest) is generally less than 10% of state and local government budgets, so defaulting won’t go very far in solving budgetary problems. Additionally, there are strong constitutional and statutory protections in place to protect bondholders including a requirement for a balanced budget in most states.
The chart below illustrates another important point. As bad as the municipal debt problem is, the states’ debt burden pales in comparison to national government debt worldwide.