In November of 2007, I wrote a column here calledNow Is the Time to Offer Clients a Muni Bond Review. I observed that "many investors have developed such deep attachments to munis that they couldn't be pried away from them with a crowbar…But now may be the time to try – or at least to suggest a thorough review of muni holdings and clients' objectives."

http://www.freeerisa.com/news/feed/article.aspx?ArticleId=11

Shortly after that column was posted, the municipal bond market crumbled, yields spiked, and some tax-exempt bonds and funds lost up to 50% of their value, peak to trough.

Then came a remarkable turn of events. Muni yields stabilized, and bond prices staged a comeback. Buy-and-hold muni investors have now recaptured much of their 2008 losses. Meanwhile, most "real world" conditions and events underlying the $3.4 trillion U.S. municipal bond market have continued to deteriorate.

At this point, the muni market is set up for a "perfect storm" that could damage portfolios for years. In this column, I'll offer information you can use to help your clients evaluate holdings and make decisions. Specifically, I'll explain why this is a good time to emphasize some (but not all) broadly diversified, tax-exempt mutual funds, and I'll suggest specific muni strategies to advocate and avoid.

Deadbeat Debtors and Blue-Chip Borrowers

A passionate debate is brewing about the municipal bond market. Those who think munis are fundamentally healthy base their belief on tradition, faith and a view that this market is homogenous and ultimately "too big to fail." Those who believe the market is unhealthy view it as a varied mosaic of credit risk and they are focusing on details, including negative developments already in 2010.

The first point to make to your clients is that the U.S. municipal bond market is not homogenous. It ranges from "deadbeat debtors" to "blue-chip borrowers." Fortunately, you can use a variety of resources to sort them out.

To illustrate, let's begin with an analysis of how much money states owe today, expressed in terms of Total Debt per Person. Using the resources described below, you can perform similar analysis on your state of residence. We've added together four components of debt: 1) Projected fiscal year 2010 fiscal deficits; 2) Unfunded pension liabilities; 3) Unfunded retiree health care and other non-pension benefits; and 4) Total municipal bond principal outstanding. We then divided the total by projected 2030 population to give states the benefit of future growth.? The tables below summarize the Bottom 10 and Top 10 states.

Bottom 10

Top 10

?

Sources:

For state-by-state unfunded pension benefits and retiree health care and other non-pension benefits:The trillion dollar gap: Underfunded state retirement systems and the roads to reform; The Pew Center on the States; February 2010; pages 4 and 6. http://downloads.pewcenteronthestates.org/The_Trillion_Dollar_Gap_final.pdf

For municipal bond principal outstanding:Municipal Bond Credit Report, Fourth Quarter 20009, page 10. http://www.sifma.org/uploadedFiles/Research/ResearchReports/2010/Municipal_MunicipalReport_20100208_SIFMA.pdf

For U.S. Population: U.S. Census Bureau, U.S. Population Projections, Table 1; Ranking of Census 2000 and projected 2030 state population: www.census.gov/population/projections/PressTab1.xls

There is a huge difference in debt burdens between the most fiscally prudent states and the least – more than four times as much per capita. While this analysis relates mainly to state general obligation (GO) debt, the heaviest state debt burdens are being shifted down to counties, cities, towns and municipalities.

But the taxpayers of the most fiscally prudent states will not let the problems of "deadbeat debtor" states become their problems, too. That's why the muni market is not "too big to fail," and why it is important to view it as a varied mosaic and emphasize blue-chip borrowers in every client's portfolio.

Recent Developments

Let's now look at specific recent trends and events in the tax-exempt market, almost all of which are negative, especially for deadbeat debtor states and localities.

Municipal Bond Insurance

What's left of the muni insurance market is hanging by a thread. Although about $1.8 trillion of insured bonds remain outstanding, only one writer of new muni insurance, Assured Guaranty, is very active. In 2009, the company says it insured 8.5% of new public finance issuance by par value. The company retains an AAA rating (negative outlook) from Standard & Poor's. But in March it asked Fitch to withdraw its company-level rating, after Fitch withdrew ratings on 90% of the company's underlying insured portfolio. Assured Guaranty is vulnerable to the unfolding potential default on Harrisburg, PA's $68 million of bonds for an incinerator project. In a recent 8-K filing, the company reported that its subsidiaries also have significant exposure to under-performing residential and commercial mortgage pools. Assured Guaranty also reported that its municipal insurance subsidiary has a capital ratio of 255 to 1 – i.e., 255 times as much net insured debt service outstanding as statutory capital.

Elsewhere in muni bond insurance, Warren Buffett's planned venture, Berkshire Hathaway Assurance Corp., has withdrawn from the market after a ballyhooed launch in 2008. In his most recent letter to shareholders, Buffett observed that municipal bond insurance "has the look today of a dangerous business."

One-time insurance kingpin MBIA is facing a court challenge to its 2009 plan to spin off a separate entity,National Public Finance Guarantee Corporation, to assume its insured public financing obligations. In February, a New York State judge refused to dismiss the lawsuit, brought by large banks.

Ambac's survival may rest on a lawsuit it has filed in Nevada challenging a potential $1.1 billion claim that could be due following the Chapter 11 bankruptcy of the Las Vegas Monorail Co. in January. The authority had issued $450 million (par) in insured industrial development revenue bonds in 2000. Ambac's $1.1 billion liability includes interest payments spread over decades.

State's Cash on Hand

2009 and 2010 have produced a sharp falloff in the "cash-on-hand" that state governments have available to pay bills. Cash-on-hand consists of the cash budget balance plus the stabilization ("rainy day") funds that help states meet expenses in tough times. All 50 states combined began Fiscal 2008 with $42.3 billion in cash budget balances and $32.9 billion in stabilization funds. Through the end of Fiscal 2010, these amounts are projected to decline to $9.3 billion and $25.6 billion, respectively. Expressed as a percentage of Fiscal 2010 expenditures, three states now have negative cash-on-hand and eight have total cash below 1% of total expenditures. They are Arizona (-5.7%), Pennsylvania

(-4.7%), California (-3.7%), Hawaii (0.4%), Kentucky (0.5%), Rhode Island (0.6%), Alabama (0.7%) and Wisconsin (0.7%).

For details on state finances in Fiscal 2008 and 2009 and Fiscal 2010 projections, seeThe Fiscal Survey of States published in December of 2009 by the National Governors Association:

http://www.nga.org/Files/pdf/FSS0912.PDF

State Misery Index

State budgets are tied to trends in real estate prices and the unemployment rate – and neither show signs of improving very fast. The blog Calculated Risk tracks state-by-state rates of unemployment and mortgage loans delinquent or in foreclosure. Added together, these percentages create a "state misery index" that can indicate continued exposure to negative trends. The highest total misery rates at the end of 2009 are shown below.

The lowest misery indexes are in North Dakota (9.4%), South Dakota (11.3%), Nebraska (13.2%) and Minnesota (13.6%).?

www.calculatedriskblog.com/2010/03/states-seriously-delinquent-mortgages.html

Cashflow and Yields

2009 was the year of "yield panic" in the bond market. As money market rates hovered just above zero, investors raced frantically to find yield-generating substitutes. The table below shows net cash flow into all U.S. bond funds and municipal bond funds by year from 2007 through 2009

Source: Investment Company Institute

More net cash flowed into muni bond funds in 2009 than in the previous six years combined, and as a result bond prices and returns soared. The average national long-maturity fund achieved a total return of 13.58% for the 12 months ending 3/5/10, according to Morningstar. The spread between muni yields and Treasuries of comparable maturity, which had spiked as high as 180% for 10-year maturities in early 2009, has now fallen to 80%, a bit below the historic long-term average. Despite deep deterioration in municipal finances of the past two years, munis now are selling at lower yields relative to Treasuries than they have historically. But it won't last.

What would be the impact on the price of a 10-year tax-exempt AA-rated bond now yielding 3.0%, if the spread to Treasuries increased to 100% while Treasury 10-year yields increased by 50 basis points? The bond would lose about 9-10% of its principal value – about three years' worth of yield.

Defaults

Historically, only about 1.5% of municipal bond issues have defaulted over their lives, and that pattern continued through 2007. But in 2008 and 2009, a total of 345 issues defaulted on $14.5 billion in principal, according to theDistressed Debt Securities newsletter. Already in 2010, there have been three large default situations: the Greenville southern Connector toll road ($200 million), the Las Vegas monorail ($450 million), and potentially the Harrisburg Authority's incinerator bonds ($68 million). Also looming over the market is the technical default on interest payments by Jefferson County, Alabama, which began in mid-2008. The county has not yet declared bankruptcy and is reported to be in continuing talks with bond investors to restructure debt. An outright default on the county's $3.2 billion bonds would be the muni market's largest ever.?

Ratings

State general obligation (GO) debt ratings remain relatively high. Only four state ratings were downgraded in 2009: Arizona, California, Illinois and Michigan. California now has the lowest rating of any state (S&P: A). Despite their deteriorating finances, New York, New Jersey and Pennsylvania have retained AA ratings from S&P.

Nationally in 2009, Standard & Poor's upgraded 2,265 municipal bonds while downgrading 637 – a ratio of almost 4 to 1, according to the Securities Industry and Financial Markets Association (SIFMA). Fitch upgraded 209 bonds while downgrading 233 – a ratio of a bit less than 1 to 1.

How can ratings actions for two leading agencies be so far apart? And how can S&P see such ratings sunshine in the middle of the worst fiscal crisis for state and local government since the Great Depression? Whatever the answers are, they don't make much sense.

For details from SIFMA's Municipal Bond Credit Report for 2009, see:

http://www.sifma.org/uploadedFiles/Research/ResearchReports/2010/Municipal_MunicipalReport_20100208_SIFMA.pdf

Expanding Federal Role

State and local governments would be in even worse shape if not for massive federal support including $135 billion in emergency funding through the American Recovery and Reinvestment Act of 2009, $87 billion in additional Medicaid funding, and $48 billion through the State Fiscal Stabilization Fund. The bulk of this money will be spent by the end of Fiscal 2010. Where will the states then turn for funding to replace it?

According to the Heritage Foundation, the total amount of federal funding passed to states increased by 21.2% from 2008 to 2009. One-third of this increase went to just two states, California and Michigan. "When the federal funds expire, states will have to make up the difference in order to maintain level spending," the Heritage Foundation wrote. "The stimulus will have simply shifted the source of funds from state to federal and back again to states."

Tax Receipts

Total state and local government tax receipts from personal income tax fell by the most in modern times on an annual basis in 2009, by 19.3%, according to the Bureau of Economic Analysis. Only six states – California, Connecticut, New Jersey, New York, North Carolina and Oregon – have enacted meaningful increases in state income tax rates.

Sales tax receipts fell by 4.6% in 2009, despite increases in the tax rate enacted in several states. In total, state tax collections declined by 7.4% in 2009, compared to 2008.

For details:http://research.stlouisfed.org/fred2/series/ASLPITAX

Spending

Many of the spending cuts enacted by states in the past year have produced temporary benefits or shifted costs down to local governments and school districts. According to the Heritage Foundation, 30 states have reduced aid to public school K-12 education. Meanwhile, the total full-time employment headcount of all 50 state governments has remained constant at 2.63 million.

States are powerless to reduce their fastest growing line item – Medicaid, which now accounts for accounts for 21%of total state spending. In recent years, state Medicaid expenditures have been increasing by 7-8% annually. Proposed health care reform initiatives would enroll an additional 15-20 million more people in Medicaid, with most states expected to pick up even larger tabs in the future.

Specific Guidance for Municipal Bond Investors

Here are a few ideas for helping your clients make timely muni decisions:

• Decrease muni exposure – Any of several events described in this article could rattle the municipal bond market in 2010 and 2011, driving yields higher and prices lower. Each client should consider whether any yield advantage (after tax) compared to Treasuries or high-quality corporate is worth the extra risk.

• Emphasize diversification – Municipal default rates will keep increasing, especially for smaller issuers and industrial development bonds. Urge clients to spread the risk of default broadly by using municipal bond funds.

• Avoid long maturities – Most economists expect all interest rates to increase over the next few years, especially if the economy recovers. The combination of rising rates in general and tightening muni/Treasury spreads would inflict the most price damage on issues with maturities over 10 years. In this environment, individual investors should avoid all municipal issues with maturities of 20 years or longer, including the new taxable Build America Bonds.

• Deemphasize insurance and ratings – Municipal investment decisions can no longer rely on ratings or municipal bond insurance for comfort. If ratings must be used, emphasize the more conservative ratings of Fitch.

• Choose active managers who perform their own credit analysis – Look closely at the portfolios of actively municipal bond funds to see how their managers are thinking. In national funds, look for GO issues of conservatively managed states such as North Carolina, Virginia, Minnesota and Texas. Avoid heavy exposures to New Jersey, California, Illinois, New York, and Pennsylvania.

• Don't chase yield – Municipal funds that are chasing the highest yields do so by stretching maturities, moving down the quality ladder, or using leverage. Yield-chasing funds have been burned in the past, and they will be again.

• Keep focusing on "true TEY" – As I've explained in previous columns, you can no longer calculate the "Taxable Equivalent Yield" for a senior investor based on income tax bracket alone. For example, it's theoretically possible for up to 100% of a retired investor's "tax-exempt" income to be eaten up by increased Medicare premiums. See: http://www.freeerisa.com/news/feed/article.aspx?ArticleId=20

In Summary

Buy-and-hold municipal investors are fortunate to have recouped 2008′s price declines in 2009. They should count their blessings, because the next few years in munis could look a lot more like 2008 than 2009. The imbalance between state and local government spending and revenues is structural, not cyclical, and can't easily be fixed. During 2009 state-local budget problems became tethered to federal government life support that is by no means assured to continue.

Many deeply indebted state and local governments have three separate constituencies to consider: 1) their taxpayers; 2) recipients of pensions and other benefit programs, such as retiree health care; and 3) bond holders. They can try to balance all three interests – or they can favor some constituents over others. Historically, bondholders have always come ahead of other constituents, but that will change.

Taxpayers are voters, and many feel they can't dig ever deeper to pay increasing tax loads, especially when state/local government services keep declining. Most pensioners and retiree health care beneficiaries live inside state and local jurisdictions and vote there. On the other hand, municipal bond investors are widely dispersed and many don't live, work or vote locally. They will be perceived as predominantly wealthy or affluent investors who know the risks and can afford to "share the pain."

Barring a strong and sustained economic recovery, the first default of state GO debt since the Depression probably will take place in the next decade, even if it is structured to avoid the "D word." Whether it occurs sooner or later, the taxpayer revolt against excessive state and local debt burdens will be driven from the grassroots up.

The "enough is enough" stands against crushing debt loads already taken by taxpayers in Vallejo, CA, Jefferson County, AL, and Harrisburg, PA, may be the first shots in the revolt. The historic stigma against municipal defaults will change, much as the social stigma against homeowner foreclosures is fading now.

Even if there were no increase in default rates, the perfect storm that muni investors are facing is serious. The Bernanke Fed has driven short-term interest rates so low that a yield-driven stampede developed, at the same time massive federal aid was being pumped temporarily into state and local coffers. Muni bond investors benefitted on both ends – but now those events will unwind. Yields will rise and the muni/Treasury spread will narrow. Meanwhile, some muni investors will find that the true TEY they are getting isn't as advertised.

Help your clients look carefully at muni holdings now, and emphasize the diversification and active management of mutual fund managers who can separate blue-chip borrowers from deadbeat debtors.