#1: Municipal Bond Insurance

An ever-diminishing portion of outstanding municipal bonds is protected by insurance. In 2012, only 27 percent of outstanding bond principal was insured, compared to 57 percent at the bond insurance industry's peak in 2007, according to SIFMA. 

One new insurer, Build America Mutual Assurance, launched in 2012 with an AA rating from S&P.  It is the first new company to enter the market since Berkshire Hathaway Assurance Corp. in 2007, and joins Assured Guaranty Ltd. (rated AA-) as the only active writers of insurance.

The most significant 2012 event in this industry may have been Berkshire Hathaway's announcement in August that it had terminated $8.25 billion of municipal credit protection contracts originally sold to Lehman Brothers in 2007. Analysts interpreted it as a sign of Berkshire CEO Warren Buffett's negative outlook on municipal finances.

Here is a recent Standard & Poor's report on the municipal bond insurance industry.

#2: Legal Challenges and Risks

Traditionally, bondholders have enjoyed strong legal protections when municipalities have reorganized under Chapter 9 of U.S. bankruptcy law. Now, nuances of the law are being tested in a complex court challenge by CalPERS, the giant California pension fund, against the bankrupt city of San Bernardino. CalPERS argues that its claim for $10 million of unpaid pension contributions should stand ahead of other municipal bills and creditor claims. In Stockton, another bankrupt California municipality, critics have charged that the city is attempting to use bankruptcy to force a court-ordered cramdown on bondholders, while maintaining above-market labor contracts and pension costs.

Reuters recently published an informative article on Chapter 9 cases.

#3: The Proposed 28 Percent Limit

As the ninth largest federal income tax expenditure, the tax exemption of municipal bonds will cost the federal government $200 billion over the 2010-14 period, according to the Joint Committee on Taxation. In the 2011 American Jobs Act, the Obama Administration proposed to increase federal revenue by placing a 28 percent bracket cap on tax-exempt interest of single-filers with incomes over $200,000 and joint filers over $250,000.

Example: In 2012, the top marginal effective tax rate on interest for a California taxpayer was 43.6 percent. In 2013, that could rise to 52.6 percent if all scheduled tax increases take effect. If the value of tax-exempt income is limited to 28 percent at all levels, the effective tax rate on a California taxpayer's municipal income could increase to as high as 24.6 percent (52.6 percent – 28 percent) in 2013. Check out the top marginal effective tax rates for your state in 2012 and 2013.

#4: Declining State GO Credit

In its 2012 State of the States report, the consulting firm Conning reported that "the disparity between state credit quality has widened, as measured by our metrics." In 2012, both Moody's and S&P downgraded the GO credit ratings of Illinois – to A2 and A, respectively – based largely on underfunded public pensions. Moody's also downgraded Connecticut to Aa3 and Pennsylvania to Aa2.

According to an analysis by Barron's, Connecticut and Illinois have the highest "debt + pension liability to GDP" ratios in the nation – 17.1 percent and 16.3 percent, respectively. In Conning's 2012 overall ranking of state credit quality, Illinois ranked 49^th and Rhode Island 50^th, based on 13 indicators.

You can view Conning's 2012 report and state rankings here: Barron's 2012 report is here: and you can check GO ratings for all states here.

#5: Declining Local Tax Revenue

Conning observes: "While state revenues have been recovering, local tax revenues have been falling. This is primarily due to the decline in home prices, which is lowering assessed values and ultimately property tax revenues, the largest source of local governmental revenues." State and federal aid to local governments also has come under pressure.

In 2012, local government stress was most visible in California, where three municipalities – Stockton, San Bernardino and Mammoth Lakes – declared bankruptcy. In 2013, the trend could expand to Pennsylvania, where the cities of Scranton and Harrisburg are under growing financial pressure. Scranton, the state's eighth largest city, has cut the pay of all municipal employees to minimum wage, and it is still out of cash. The city's public pension plans have a funding ratio of only 34 percent.

Pennsylvania's Auditor General recently released a report showing that 52 of the state's 2,600 pension plans are "severely distressed" with an average funding ratio of just 45 percent. The Philadelphia School District faces a cumulative budget deficit of $1.1 billion over the next five years and is planning to close one sixth of its school buildings by June.