Tuesday, March 30, 2010

Municipal Debt and State Budget Woes: Accident Waiting to Happen?

Municipal bonds (TFI; above) have fallen from recent highs and have not exceeded their 2009 peak thus far in 2010. Nonetheless, they remain popular investments, given rising tax burdens for high-income investors and a shift toward taxable debt among municipalities (the Build America Bonds).

At present, 10-year triple-A rated, general obligation municipal debt offers an average yield of 3.23%, up from 2.95% six months ago, according to Bloomberg. The current yield on two-year debt is .69%, down from .75% six months ago. So we've seen some steepening of the muni yield curve. Muni rates overall are attractive relative to Treasury debt, but not screamingly so as they were during the 2008 bear market, when tax free rates were substantially higher than taxable Treasury rates.

A recent New York Times feature highlights the very significant debt burdens of many states. As the article notes, ratings agencies continue to give the states stellar grades despite debt that approaches the levels of troubled eurozone economies. Particularly troubling is the very high debt levels associated with pension obligations. It is difficult to see how states can endlessly kick the debt can down the road, and it is difficult to see how budgets can be balanced in troubled economic times, particularly when tax revenues to the states are down. As Rogoff and Rinehart ominously note in the Times article, "When an accident is waiting to happen, it usually does."