Muni Bonds: The Most Dangerous Bonds to Own

US News

If an investment product promised safety, potential appreciation, and tax-free income would you bite? Many high-income earners, affluent savers, and, to a lesser degree, mutual fund investors have taken the plunge and turned over almost $4 trillion to state and local municipalities that promise this utopic mix of protection, growth, and tax efficiency. With tax rates rising, who can blame them for buying municipal bonds? So, is this smart investing or is there a hidden danger?

BAD MATH

With the burgeoning debt loads in almost every corner of this great country, could owning muni bonds be fraught with untold risk? Let's examine this question by starting with the basics. Say, I come to you and ask for a loan to fund spending of $120,791 and I have an income of $101,000, would you loan me money? Why not? Because I spend more than I make? Interestingly enough this example is from the bottom line financials from my home state of Ohio (with a few zeros removed of course).

Andrew Zarivny/Shutterstock

ARE DEFAULTS RARE?

With scenarios of overspending found in virtually every state and municipality it's not hard to imagine that defaults will continue into the future. Here's a list of some of the largest defaults from Moody's Investors Service to further illustrate the point of how fragile a muni bond can be:

--$3.47 billion. Jefferson County, Alabama. The county's sewer revenue bonds went into default and the general obligation bonds soon followed.

--$2.25 billion. Washington State. Bonds issued to finance a nuclear power plant defaulted. Bondholders recovered about 40 percent of their principal and interest...nearly 10 years later.

--$439 Million. Las Vegas. Muni bonds that supported the monorail defaulted due to mechanical problems and lack of ridership. Subsequently, the company who insured the bonds (Ambac) filed for bankruptcy, raising the question about other the solvency of other bond insurers.

--$341 Million. Stockton, California. Because of a lack of fiscal stewardship the city filed for bankruptcy last year. Some of the bonds are "backed" by insurance, but the city has requested bondholders shoulder some of the uninsured losses.

--$262 Million. Harrisburg, Pennsylvania. The state capital fell into default when it failed to honor payment guarantees on a troubled incinerator project.

I'm not implying that there is a default epidemic...yet. After all, critics to my argument would say that muni bond defaults are relatively rare. They cite rating agencies statistics showing historically low patterns of default, well under 100 defaults in total. But rating agencies only track muni bond defaults on municipalities that they rate. A recent finding from the Federal Reserve Bank of New York, however, tells a different story. The Fed discovered 2,527 muni bond defaults from 1950-2011, trumping the fanatical claim of low default rates among muni bonds.

HOW TO OWN MUNIS, IF YOU MUST.

While I'm personally not a fan of muni bonds (specifically in the current environment) I understand and appreciate their allure. If you must absolutely have an allocation to munis I believe the best avenue is to own diversified muni bond ETFs, or for more control and transparency, a separately managed fixed income account that can be custom-tailored to you.

Robert Russell is the best-selling author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and has been interviewed by CNBC, FOX Business, The Wall Street Journal, and several other national and international media outlets.



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