Dealing with Risk in Municipal Bonds

Municipals only make up only 10% of the U.S. bond market.

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It’s been nearly two years since bank analyst, Meredith Whitney, predicted “between fifty and a hundred counties, cities, and towns in the United States would have ‘significant’ municipal bond defaults starting in 2011, totaling ‘hundreds of billions’ of dollars in losses.” According to BlackRock, who manages billions in municipal bonds, there were 119 municipal defaults in 2011 totaling $6.1 billion. Ms. Whitney recently backed away from her prediction, saying she doesn’t advise clients on municipal bonds.

A recent article in Barron’s took a hard look at the municipal bond market, with a particular focus on the mounting pension shortfalls. Barron’s ranked the states by adding the unfunded pension liability to the state’s debt to GDP, in an attempt to identify which states have the most risk. It is clear that some states will have to make some difficult decisions to get their pension liabilities under control.

I’m not trying to make predictions about the future of the municipal bond market. It’s important to remember why bonds are part of a balanced portfolio. We hold bonds as a place to store gains in good markets and to provide stability during bad markets. It is critically important that the bond portfolio hold its value when the market drops. In this situation, the bonds become over-weighted, causing the portfolio to be rebalanced by selling bonds to buy stocks. Actively rebalancing a portfolio forces you to buy low and sell high.

Municipal bond portfolios should be diversified by municipality and type – revenue and general obligation. Pay attention to unfunded pension liabilities and what the municipality is doing (if anything) to address their pension problems. Municipals only make up only 10% of the U.S. bond market. It is also prudent to diversify outside of municipal bonds into corporate bonds and U.S. government agencies. The interest on corporate and government bonds is taxable, so they should be held in tax-deferred accounts when possible. Interest on municipal bonds is tax-free.

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