Municipal Bonds: A Delicate Balance

In his column, Metronomics, Andrew Thompson explains that even though muni bonds have taken a hit, investors are still buying them.

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In the world of securities, municipal bonds – like their paternal counterpart, Treasury bills – have always been the conservative, don’t-rock-the-boat, unexciting-yet-safe option. You won’t make a killing, but the market probably won’t kill you, either. In the past, they’ve been favored as a sort of bomb-shelter security when the financial skies seem to be falling.

What a difference a recession makes. Earlier this month, the credit-rating agency Moody’s released a statement forecasting a negative future for all municipal bonds – the first time it had ever released a blanket judgment for states and townships indiscriminately. The economic crisis destroyed many of the bond insurers who backed muni bonds, and the housing collapse has wreaked havoc on property taxes nationwide, seriously dampening investors’ confidence that the debt will be repaid. It’s not just housing, either: The crisis has become so widespread that any township with a slightly specialized economy in any given sector (Michigan and Illinois have been hit by manufacturing, Connecticut and New York by finance, and so on) has been so busy slashing services and rebalancing their budgets that bond holders have wondered if they would be forgotten. And since consumer spending has become a recent memory, sales-tax revenue has too.

But munis look increasingly popular to investors these days, despite the downgrade. Whereas annual yields tended to trail T-bills in the past, they’ve now shot ahead roughly 2 percent for a 30-year bond to an average of about 5.3 percent. Cities have jacked up their rates to entice investors and thus plug certain budgetary holes. While most cities aren’t allowed to incorporate anticipated bond proceeds into their budgets (since their budgets have to be balanced every year), they can issue bonds to fund capital projects like sewers and stadiums. And if the monies originally budgeted suddenly dry up, bonds become a last-ditch effort to make sure things water systems still work.

Investors, who we can assume mostly live in the tax bracket that will see a 2.1 percent increase soon, are also looking more to tax-exempt muni bonds because of the anticipated tax hike. And the stimulus plan included even more tax benefits for buyers of munis.

So cities are saddling themselves with debt to stay alive. Are they in trouble? Well, if analysts’ declarations of deflation are true, then maybe not. When (let’s keep saying “when”) the economy rebounds and the dollar regains its value, the bonds – especially if they’re more long-term – will be easier to pay back. Deflation is always bad news for individuals with outstanding debt. But for the ones who are burying themselves in it, it can make the future a little less unbearable.

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