Attack of the Muni Monsters

Story Highlights:

• Some predicted 2011 would be the year of the municipal bond default, causing some investors to flee muni bonds.
• But nearly halfway through the year, the numbers are playing out differently.
• Investors should be wary of panic-inducing predictions that can lead to incorrect investing decisions.

Humans seem to have a morbid fascination with predictions of doom. A quick search of the Internet Movie Database yields an impressive list of Armageddon-related titles, depicting Earth’s destruction by [you name it]. According to the Mayan calendar, the apocalypse will arrive in 2012 (which they supposedly foresaw 500 years ago, but somehow they couldn’t see those pesky conquistadors right around the corner)—and a sizeable industry has sprung up marketing survival guides and supplies. Some even believe the end comes this very Saturday! Doomsday bunker, anyone?

But this fixation isn’t limited to Armageddon—it also extends to financial doom predictions (which seem far harder for many folks to shed than theories promoted on extended cable TV networks). Folks will likely be captivated by economic fears as long as there are free markets. And this year is no exception. Headed into 2011, talk was this would be the year of the widespread, devastating municipal bond default. The theory: Persistently low state revenues and increasing budget deficits would force states to default on municipal bond obligations. Approaching the year’s halfway point, let’s check in on this prediction.

Technically speaking, there were 12 defaults in Q1 2011, representing a mere $277 million of outstanding debt—about 0.1% of the US municipal bond market. That includes any bond that lacked a full scheduled principal or interest payment as well as mandatory sinking fund payments. Hardly the commonly held view of default doom where bondholders lose the entirety of their investment—and a far cry from the sizeable defaults predicted. Consider: Nearly halfway through 2011, not a single major municipality has defaulted.

So what’s really going on? For one, state and local tax revenues are rising, up 4.7% in Q4 2010, with preliminary data showing accelerating growth in the first quarter of 2011. Tax revenue growth has outpaced spending growth, so state and local governments have reduced borrowing. In fact, in Q4 2010, net borrowing activity was down more than 80% from its peak in Q3 2008. And contrary to popular beliefs, tax revenues aren’t increasing because of tax hikes but because personal income, consumer spending and corporate profits have rebounded sharply.

By and large, investors who may have fled the municipal bond market last year on dire predictions of broad-based defaults seem to realize things are improving, not worsening—bolstered by improving deficits in even some of the worst-off states. The cost of insuring against state and municipal default has also recently fallen. And as investors have returned to the market this year, municipal bond yields have fallen, reducing state and local governments’ future debt servicing costs—and the likelihood of future defaults.

Granted, there’s still time this year for states or municipalities to default, but at this point, it appears defaults will be much milder than initially feared, especially if economic growth continues apace and states make further progress closing budget deficits. As investors, it’s absolutely critical to determine if there’s any validity to panic-inducing predictions. And that applies whether we’re talking about zombie-or economic-related Armageddon.