Fear of Defaults Changes Investors’ Views on Municipal Bonds

For some time now, municipal bonds have been synonymous with conservative, safe investments. But that presumption may be changing given the fact that three municipalities in California – Mammoth Lakes, San Bernardino and Stockton – have declared bankruptcy and, in turn, want their bond investors to take reductions on the principal and interest payments that they’re due.

Another city located in central California, Atwater, may soon follow similar ranks. Last month, it formally announced a fiscal emergency, making it one step closer to declaring bankruptcy.

As reported Oct. 21 by Investment News, the recent bankruptcies in California could be just the beginning of many more to come. Recent reports from ratings agencies Fitch Ratings Ltd. and Moody’s Investors Service suggest that after decades of steady performance, municipal bonds – as well as municipal bond funds – may see higher default rates and poorer performance in the not-so-distant future.

The municipal bond market is big – an estimated $3-plus trillion industry.

A municipal bond itself is a bond issued by a local government, government entity, cities, counties, school districts and public-sector authorities and their agencies. Municipal bonds may be general obligations of the issuer or secured by certain revenues. In the United  States, interest income received by holders of municipal bonds often is exempt from federal income tax and from the income tax of the state in which the bonds are issued.

Potential trouble in the municipal bond market has been predicted by several financial analysts over the past few years. In 2010, in an interview by “60 Minutes,” analyst Meredith Whitney stated there “is not a doubt in my mind” of future defaults, perhaps totaling hundreds of billions of dollars, because many states, cities and counties can’t pay their bills.

Indeed, for at least a decade, a growing number of state and local governments have been pretending they could afford pension promises and spending without facing the reality of how they would actually make good on those promises.