U.S. munis: no disaster, but still vulnerable

May 10, 2011

By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Call it headline risk. Bad press, along with stressed U.S. state finances, hammered America’s local government debt last year. But the $3 trillion market was never in as bad shape as the doomsayers made out. Still, an improving market — gains in 18 out of the last 19 trading sessions through Monday, according to Janney Capital Markets — isn’t immune to stumbles as dysfunctional states tackle budget woes.

Bank analyst Meredith Whitney last year made a controversial call that “hundreds of billions of dollars” of munis would go bad. That helped tank the market. Nothing yet looks remotely on track for that kind of disaster. There are less than $10 billion of defaulted bonds outstanding — with just $28 million of those coming from the safest instruments like bonds backed by a U.S. state, according to Municipal Market Advisors. Admittedly, though, another $22 billion of bonds are showing signs of stress. That bears watching, especially if the U.S. economy sputters again.

In the meantime, prices have recovered some of their losses and yields on the average AAA-rated 10-year muni bond have dropped about 13 percent to 2.7 percent so far in 2011. Low Treasury rates stemming from the Federal Reserve’s easy monetary policy have helped, but so has a dearth of supply — the $67 billion issued so far this year is less than half the amount sold in the same period last year. That’s something else to keep an eye on, as a surge of issuance could soften the market.

Then there’s demand. Outflows from muni bond mutual funds have slowed. They are running around $1 billion a week, according to mutual fund tracker Lipper. That’s less than half the amount exiting earlier this year, and the aggregate outflow of nearly $50 billion since mid-November is only about a third of the inflow seen between 2008 and late 2010. But a few of those bad headlines and investors could reach for their wheelbarrows again.

Though the market seems stable for now, the state finances of the likes of California and Illinois have an outsized influence on investors’ trigger fingers. The next fiscal year begins on July 1 for 46 of the 50 states, and budget negotiations will gather intensity in the coming weeks. Throw in concern over the federal government’s debt ceiling, and a few jitters — deserved or not — could easily rattle munis.

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