Muni bonds taking a double hit

It has been rough sledding in the world of municipal bonds (also known as tax-exempt bonds) for several months. State and local government have been in the news for all the wrong reasons: bankruptcies (Vallejo, CA) and threats of bankruptcies, mushrooming budget deficits, burgeoning debt, sluggish tax revenue growth, falling property tax revenues and various contractual problems with unionized municipal and state workers.

A double whammy for muni bond investors

For investors in muni bonds, it has been a double whammy as fears of municipal deficits have added the specter of default to an already difficult environment of rising interest rates.

At every level, government is spending more, deficits are soaring and vast amounts of new debt are being issued...

...Since late August, when Mr. Bernanke foreshadowed the Fed’s second round of bond buying, the yield on 30-year Treasury bonds has increased to nearly 4.6%, a jump of 30%. Over the same period, Municipal Market Data’s AAA-rated 30-year muni benchmark has seen yields surge to 5%, an increase of 36%. That has spelled big losses for investors, since bond prices move in the opposite direction of yields. Long-dated bond prices are particularly sensitive to such moves because investors are locked into the paper for an extended period.

Rising Treasury yields are one response to the Fed’s money printing, which risks inflation and interest-rate increases down the line. Muni yields have risen somewhat faster because worsening state and local budgets also have raised the specter of muni credit risk.

But muni-market bulls focused on refuting Ms. Whitney’s argument about credit risk tend to underplay the big impact of a reflating economy, to say nothing of the end of the Build America Bonds federal subsidy. The bond program helped soak up heavy muni issuance by luring non-tax-exempt investors into the market, who have now left. These last two factors explain much of the increase in yields…

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