Avoid These Securities

February 26, 2010

One sector of the financial markets that is greatly underpricing risk today is municipal bonds. State and local governments are facing extraordinary budget pressure. The recession has eviscerated tax revenues, but spending requirements have not dropped. During the last fiscal year, some state and local governments relied on federal stimulus money to balance their budgets. But federal handouts cannot be relied upon indefinitely. The federal government has funding problems of its own. And tax increases aren’t always an option.

To deal with extraordinary budget pressure, some state and local governments are considering Chapter 9 of the bankruptcy code. Chapter 9 provides municipalities with protection from creditors so they can develop a plan to pay off debts. Chapter 9 is rarely used, but in the current economic environment, municipal bankruptcy filings may be unavoidable. Some investors are ignoring this risk. These optimists cite low historical default rates and high recovery rates in the event of default. But savvy successful investors recognize that the past is an unreliable predictor of the future.

Bloomberg reports that local government revenue fell 6.7% in the third quarter of 2009, and state tax collections through the first three quarters of 2009 fell the most in 46 years. Elevated municipal defaults are, in fact, possible. And for those investors who believe that municipal bond insurance companies will pick up the tab in the event of default-think again. An avalanche of municipal defaults would quickly push municipal bond insurance companies into insolvency.

If your portfolio is overloaded with munis, it’s time to think about pruning positions.