Most investors have some municipal bonds in their portfolios, either through individual holdings, mutual funds, or exchange traded funds.  Municipal bonds are generally considered among the safest investments.  That viewpoint has been challenged this year due to a few well-publicized defaults and a recent Federal Reserve report that the default rate may be higher than previously reported. 

Let’s separate the facts from the hype.  First the hype:  In December of 2010, in an interview on 60 Minutes, financial analyst Meredith Whitney stated that there would be “hundreds of billions of dollars” of municipal defaults in 2011.  Following her statements on the popular prime-time news show, a wave of municipal bond selling ensued.

Now for the facts:  In 2011, approximately three billion dollars of defaults occurred.  This equates to about one percent of Ms. Whitney’s forecast and is roughly the same amount that defaulted in the prior year.  To put the three billion dollars of defaults in perspective, the entire market for municipal bonds is valued at over three trillion dollars.

In 2011 and 2012, more hype ensued as news outlets trumpeted the municipal defaults of Birmingham, Alabama’s Jefferson County, Stockton, California, and Rhode Island’s Central Falls.

Consider the details of the Central Falls bankruptcy case.  It is not as if this bankruptcy came as a huge surprise.  Central Falls is the smallest city in the smallest state and it has a terrible economic environment.  Approximately 25% of its population lives below the poverty level.  The bond issue was a general obligation of the city, meaning that it is essentially an IOU without a specific revenue stream to fund it.  Surprisingly, Central Falls is emerging from their 2011 bankruptcy filing this year, and the bondholders are being made whole!  The bond holders are being repaid while other city stakeholders are hurting.  Government workers were laid off, wages were frozen, and property taxes were raised.  The bondholder repayment in Central Falls is not typical, but in many municipal bankruptcies, the bondholders are not entirely wiped out.

Here are some other facts related to municipal bond investing.  Moody’s, which is one of the largest bond ratings agencies, has published the default rates of the municipal bond market going back to 1970.  Their statistics indicate that about one-tenth of one percent of municipal bonds typically goes into default on an annual basis.  To be fair, the Moody’s analysis of the municipal bond market only included bonds for which a rating was issued.  Many municipal bonds are unrated.

The Federal Reserve released a study this summer that found a much higher municipal bond default rate than Moody’s because the Federal Reserve analysis included all bonds regardless of whether their issuers paid to have their bonds rated.  However, even the Federal Reserve’s annual default rate for municipal bonds is far lower than the default rate for corporate bonds suggesting that municipal bonds are among the safest bonds available.

While municipal bond managers typically have the latitude to buy unrated bonds, they will typically do so only when they have performed their own due diligence and have a high degree of conviction that the revenue streams supporting the repayment of the bonds are stable.

The Vanguard Intermediate Term Municipal Bond Fund is one of the largest and most popular municipal bond mutual funds in the market.  This fund has close to $40 billion of municipal bonds spread over 3,700 issues.  Over 95% of the bonds in the Vanguard Fund are rated AAA, AA, or A.  Less than one half of one percent of the bonds are unrated.  Vanguard diversifies their fund to avoid the risk of a default in any one bond having an adverse impact on the entire fund.

Looking forward, there are several reasons to like municipal bonds.  As of the end of the second quarter of 2012, states posted their tenth consecutive quarter of rising revenues.  The income received by the states in the second quarter was up 3% from the first quarter of the year.  Only California and Delaware did not post year-over-year revenue gains.  Those two states failed to grow revenue for reasons that were obvious to the markets well in advance.  Delaware lowered a number of state tax rates and California let a major temporary tax hike expire.  The media has detailed the rising debt obligations of the states, but much less has been written about how states are growing revenues.  As the states work to find solutions to their ballooning debts, the rating agencies maintain their confidence that the revenue streams should be sufficient to repay the bondholders.

Washington, D.C. has given us another reason to like municipal bonds.  Congress’ inability to do anything to minimize the approaching “fiscal cliff” makes municipal bonds far more attractive on a relative basis than they had been before.  The fiscal cliff, which includes the expiration of the Bush tax cuts, the expiration of the two-year payroll tax holiday, the elimination of the Alternative Minimum Tax patch, the addition of the Medicare Surtax, and proposed additional taxes on those earning over $200,000 or $250,000 jointly, will make tax-free income very attractive to those in the higher-income tax brackets.

Adding to the relative attractiveness of municipal bonds is their current yield relative to Treasury bonds.  Both U.S. Treasury securities and municipal bonds are essentially risk-free.  Since the income from municipal bonds is free from Federal income tax, municipal bond yields should be at around 70%-80% of the U.S. Treasury yields to be roughly equivalent on an after-tax basis.  For the last several months, municipal bond yields have been between 100% – 110% of U.S. Treasury yields.

While all current interest rates are at or below all-time lows, the need to have bonds in investment portfolios for income and diversification reasons remains.  Given that municipal bonds are among the safest investments available, they generate income that is not subject to federal taxation, and they can be purchased through low-cost, liquid investment vehicles like mutual funds and exchange traded funds, they will be in high demand in 2013 and beyond.  Oak Wealth Advisors has been maintaining exposure to municipal bonds and favoring municipal bonds relative to corporate bonds in 2012 in anticipation of the approaching fiscal cliff.

This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.