Normally municipal bonds are considered a very safe investment. The only reason not to invest in municipal bonds is that they are so safe that the return is low compared to stocks or even corporate bonds. Many high income investors, however, invest in these bonds because they can avoid state or federal taxes by doing so, and their tax rates are high enough for it to make financial sense.
Due to a spending spree by politicians, however, that has all been changing. Politicians have been buying baseball stadiums, city improvements, and upgrades to the town hall. Normally the fact that bonds were being created to buy these things would not be an issue – other than the fact they were paying more for the items than they would if they waited and paid cash. The trouble, however, is that they have also been increasing the levels of other services, been raising sales taxes, and promising great retirement benefits to state and city employees.
When a government expands services, people come to depend on those services, making it difficult to cut them back during bad years. The trouble with sales taxes is that they cause revenues to rise during good times, causing governments to issue more bonds and start new services, but then revenue dries up during bad times (like the 2008-2001 period). The issue with retirement benefits is that the politicians who promise them are long gone before they are due, making it an obligation on future tax payers. Because the politicians don’t need to find a way to pay for them when enacted, they can promise the moon without consequence while they are in office. Generous benefits, combined with very early retirement ages for city and state workers, has caused a huge unfunded liability to be created.
Because of this, many states and municipalities are in a critical condition and therefore there is a very real possibility that they may default on the bonds, leaving the bond holders with pennies-on-the-dollar if anything. These states (California, New York, New Jersey, Illinois among others) were able to keep paying on the bonds during the last few years because of the stimulus funds and tobacco settlement monies, but these funds have run out. This puts them in dire straights, as the bond ratings agencies have began to notice.
It may be that state and local governments will put paying the bond holders first, scale back on other spending, and be able to keep paying on these bonds. This will mean a lot of complaints, however, by the various vocal activists groups who support and government funding stream, making it politically costly to do so. The idea of state bankruptcy has been raised, indicating that was one the unthinkable is on the table. Given the results of the GM bankruptcy, it is also possible that the bond holders will not be given preferential treatment as is legally required – basically the legal agreements that are written when the bonds were issued may mean nothing.
The fact is, despite their traditional role as a place of safety, the interest rates on municipal bonds are just not worth the risk anymore. Unless the reward from an investment justifies the risk, there is no reason to invest. Municipal and state bonds now fall into that category.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing