Beware the Growing Risk of Municipal Bonds

The days of the almost unquestioned surety of the safety and returns of municipal bonds are over, and irresponsible governments, shenanigans, and unwillingness to cut back on spending has brought the municipal bond market into dangerous territory, and we ignore it at our risk.

Anyone investing in municipal bonds need to thoroughly check out the fiscal condition of the municipality issuing them, and whether or not they've shown financial discipline in the past.

There's nothing worse than a politician who thinks debt spending is an endless and magical source of revenue that has no chance of running out.

Most think the federal government will step in and save municipal bonds, but that's no longer a surety in light of the government teatering on the brink of insolvency itself.

A growing number of Americans realize the extraordinary financial danger we're in, which is the major reason the spontaneous tea party movement has risen. So the political will is shrinking as to using debt as a means of propping up unrealistic wages and projects that are simply unsustainable.

This isn't even the worst scenario though. The increasingly reckless and inept federal government instituted the Build America Bond. Remember that not too long ago?

While the name sounds patriotic, benign and positive, in reality they're the ultimate in enablement. It's like offering a junky a second way of accessing drugs when they had their original source cut off and were close to beating their addiction.

Just at a time when state and local governments were about to be forced to have fiscal discipline and limit the size of government, the ill-conceived introduction of Build America Bonds was released, and it has made things far worse than they were before. 

What were the results of the Build America Bonds in the first year of their introduction? In 2009 municipalities increased their debt by $58 billion. So now state and local governments are in far worse shape than they were before the bonds.

The Build America Bond is different than its predecessors in that it offers a higher interest rate, but are taxable as a result. The higher interest rate comes from being subsidized in part by Washington.

So at a time when the economic situation was bringing municipalities into being forced to take austerity measures and lower costs and the size of government, Washington stepped in and gave them another avenue to get their debt fix.

If you think this is all only theory, look at Vallejo, California, which declared bankruptcy and still has yet to pay the full amount owed on its municipal bonds.

In coming out of bankruptcy, the city has as part of its exit plan the idea of deferring payments on their bonds for three years.

That means bondholders don't get paid. Period. Until the three year time period is up.

The point is this could happen anywhere, and this is sure to be just the beginning of what could become many local bankruptcies. Municipal bond holders need to beware. 

The point in all of this is to realize it's no longer the former municipal bond world we lived in.

To take action based on that past world is a huge mistake, especially in the current economic environment where safety is a key factor, and other than gold, municipal bonds has been one of the major places people and institutions escape to when searching for a safe haven for their money.

We have to assume a state and a locality can fail, as we already have seen in California as well, and other states aren't that far behind them.

And if a state is failing, that has to mean a significant number of localities are failing as well.

Do your homework and perform due diligence as thoroughly as you would with any suspect, or even quality corporation. Municipal bonds and safety are no longer synonymous with one another. 

Another terrible practice which is aggravating the situation is the 0 percent interest rate of the Federal Reserve. That encourages more reckless borrowing because of the temptation of inexpensive cash.

But inexpensive cash still must be repaid, and if you've already spent beyond your means, it doesn't matter how cheap the debt is, you are in deep trouble. 

This isn't to say everything will fall apart in municipal bonds. But the safety once almost guaranteed there no longer exists. We must be much more careful and cautious than ever before, and consider them as risky as any other investment vehicle.

At the same time, states like California and New York are already insolvent, no matter how they try to spin it, and until they're willing to commit to, and have the resolve to institute austerity measures, that will never change, and we should be extremely resistant to ever putting a penny of our money in municipal bonds there until they start to change. Not say they're going to change, but actually begin to change.

All of this can change from city to city and state to state.

Don't be one of those like in the housing market who throw the dice hoping they're not the last one holding the mortgage when the bubble bursts.

That can happen in the municipal bond market as well. Do you want to be the last one holding the paper when it does? Neither do I. 

The financially unthinkable is happening before our eyes and affecting all of our lives.

We can't be in denial about this in relationship to municipal bonds, and can no longer arbitrarily invest in them assuming they're the safest thing on planet earth.

That measure of safety is long gone as politicians continue to be out of control and irresponsible, as they can't break their addiction to debt and spending.

Don't you be a naive victim of their addiction, check everything out closely if you want to invest in municipal bond, and do your own homework. The addict isn't going to reveal they're still addicted to a drug while they're asking you for money for "lunch" now are they?

No longer look at bond yields or other factors, look at the fiscal health and attitude of a locality or state in making your decisions.