The U.S. municipal bond market could be cruising for a bruising.

The same thing goes for muni-bond investors.

The danger is right out in the open for everyone to see. But investors aren’t heeding the warnings.

The bottom line: Avoid the sector, except the very-highest-rated issues; and even then, given the low yields available, there are clearly lower-risk/higher-profit opportunities for your money.

The Birth of the “Deadbeat State”

Municipal bonds – usually referred to as “munis” – have traditionally been very popular portfolio additions because of tax advantages that, in effect, enhance their rates of return.

[ad#Google Adsense]There’s also an allure because of their local nature: Investors can invest in specific bond issues that provided the money for projects such as schools, highways, bridges, hospitals or housing that actually affects the community in which the investor lives. That makes them a very tangible investment.

Investors can also more easily keep track of the creditworthiness of their state and local governments.

But there’s a problem.

Let’s call it the emergence of the “deadbeat state.”

State-and-local-government finances have taken a bigger beating during this economic downturn than during any other recession since World War II. Even worse, that beating came after the easy money available during this stretch encouraged those same governments to venture well beyond any reasonable limits in terms of their borrowing.

These states are now stuck with a bigger-than-warranted debt load – which can’t be covered by the property tax stream that’s been reduced by record-level housing defaults.

Even so, the municipal-bond market has failed to accurately price in credit risk.

For some perspective, consider this. Long-term bonds issued by Illinois – which is quickly building a reputation as a “deadbeat state” – trade at a yield that is only 2% above that of supposedly super-safe U.S. Treasury bonds. In Europe, by contrast, higher-risk Portuguese government bonds trade at a yield that’s 4% higher than solid German Treasury bonds.

This failure by investors to recognize the deteriorating creditworthiness of alleged deadbeat states’ risk becomes all the more striking for three key reasons.

First and foremost, the emerging budget crisis in many U.S. states is gaining more and more of the mainstream news spotlight, thanks to recent investigative reports conducted by such media outlets as the CBS News “60 Minutes” news magazine.

Second, given that new governors are taking office in 26 states in the New Year, investors can expect a flurry of headlines about the worst budget climate for U.S. states in a generation. In states such as New York, Illinois, New Jersey, South Carolina and Nevada, there are clearly no easy fixes – even though there’s an estimated cumulative budget shortfall of $140 billion for 2011.

And lastly, given the Republican control of the new House of Representatives, the odds of a federal bailout for Democrat strongholds like Illinois and California are likely to be very slim.

The Great Depression vs. The Great Recession

Rating agencies are relatively positive about state and municipal bonds. The lowest-rated state – Illinois – is still A-rated by all three rating agencies.

Statistics on defaults produced by the rating agencies suggest that municipal debt is considerably less risky than equivalent corporate debt. However, those statistics may not continue being true. In the aftermath of the Great Recession, risks on municipal debt may be much higher than historically experienced, and 2011 may well be the year in which that unpleasant reality becomes fully apparent.

At first sight, it is not obvious why this should be so. While the Great Recession has been deeper and considerably more prolonged than any since World War II, it is only modestly more severe than the “double-dip” recession of 1979-82 – if that downturn is considered as a single event.

Further, the rating agencies’ default rates include data from the Great Depression. And if you consider the period during which U.S. unemployment exceeded 10%, the Great Depression was actually much worse than the current unpleasantness, as well as lasting more than a decade.

For a number of reasons, however, this recession has been especially difficult for state and local governments, and even bears comparison to that deep 1930s downturn.

During that decade, state and local governments were much smaller and taxed their citizens correspondingly less. It was also a period of careful government budgeting. Hence, during a recession state and local governments could raise taxes without damaging their economic base.

It’s a much different time today.

In contrast to the careful budgeting of the ’20s, the stretch from 2001-2008 was one that saw many state budgets explode in size, lured into expansion by an excess of cheap money.

Hence, the finances of many states – California, Illinois, New York and New Jersey, for example – were already stretched going into this downturn. And that made them highly vulnerable to unexpected economic headwinds.

The housing market may have been the roundhouse punch that finally put local governments down for the count. That had been the backbone of local government finance, had enjoyed a ridiculous boom from 2001-07, and has collapsed in price since.

Except for the Florida land craze of the early to middle 1920s – a speculative frenzy, to be sure, but one that was contained in that region – there was no real-estate bubble heading into the Great Depression.

The Great Depression saw many municipalities default and one state default. That state, Arkansas, was felled in 1933, after having overspent on road projects the decade before (making it an exception to the general carefulness of state governments).

Why “Crunch Time” Has Come

Since the Great Depression, defaults have been few. The largest in the 1979-82 double-dip downturn was the Washington Public Power Supply System, which suffered from the costs of half-completed nuclear power plants.

Ordinary municipalities did not default in any number in the early 1980s, 1990s or 2001-03 recessions, although Orange County, Calif., in 1994 defaulted on debt through costs incurred gambling in the derivatives markets.

The lack of defaults in 1979-82 can be explained by the very rapid economic recovery in 1983, followed by a sharp drop in interest rates and rise in house prices.

That brings us to 2011. This time around, unfortunately, states and municipalities are not so lucky.

What’s more, even though the U.S. economy has started to recover, there can be no question that the major state and municipal defaults are ahead of us. The difficulties experienced by states and municipalities in the early years of a long downturn can be covered by reserve funds and by cutting out the ample fat in municipal budgets. In 2009-2010, the Obama administration’s “stimulus” further cushioned the downturn’s effect.

Here at the start of the New Year, while corporate income tax payments have recovered somewhat, personal-income-tax payments remain depressed – in part because of high unemployment. At the same time, property-tax payments are generally still declining as more homeowners get in difficulty and property valuations are revised downwards.

With “stimulus” payments to state and local governments unlikely in 2011, crunch time has come.

There’s still another problem this time around that makes this situation even worse: There’s a problem with municipal bond insurance. During the boom, many municipalities issued debt guaranteed by a specialized monoline insurance company, which thereby enabled the debt to be rated AA or AAA.

[ad#ChinaBlankCheck]This seemed a good idea at the time, but many of the monoline insurance companies also specialized in insuring subprime home mortgage securitizations. While their municipal insurance businesses have not produced significant losses, their home-mortgage-insurance businesses have caused them to spiral towards insolvency.

One of the monoline insurers, Ambac Financial Group Inc. (PINK: ABKFQ), filed for Chapter 11 bankruptcy protection in November and others can be expected to follow.

The bottom line is that if municipalities start making substantial claims on their monoline insurers, they may find the money is not there.

For investors, the message is clear. The municipal-bond market isn’t accounting for the risks these bonds face. So if the yield on a municipal bond looks attractive, its creditworthiness is almost certainly sub-par.

It’s a sector that you want to avoid.

Actions to Take: The municipal-bond market isn’t accounting for the risks these bonds face. So if the yield on a municipal bond looks attractive, its creditworthiness is almost certainly sub-par.

Given the low yields currently available on “munis,” there are almost certainly better places for your money. If you absolutely feel you must buy munis, stick with the very-highest-rated issues.

Better still – especially given the questionable nature of these ratings – avoid the sector altogether.

— Martin Hutchinson

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Source:  Money Morning