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Municipal Court: Investors Render a Verdict of Guilty

Many state and local governments across the U.S. are in serious financial trouble after sustained overspending. This has placed the municipal bonds issued by many such local authorities at serious risk of default.

In this municipal court, it’s the municipality itself that is on trial. The charge is egregious over-spending over a sustained period of time by state and local governments across the country. The verdict is guilty, guilty, guilty.

Now that the jury has spoken, the penalty phase of the trial is well under way. It looks like significant financial penalties are going to be imposed. Municipal issuers have been paying a significant premium to issue debt since August, when the yield on 30-year tax-exempt credit was 3.7 percent, according to Reid Smith, a portfolio manager with RBC Global Asset Management. The average tax-exempt yield for 30-year muni bonds is now 4.8 percent, he says.

That is an exceptionally high yield for tax-exempt debt, which typically has a yield of 85 to 90 percent of Treasuries, according to Smith. The yield is now 107 percent, and Smith sees little sign of that premium fading any time soon. “Right now, municipal bonds are cheaper, relative to Treasuries or corporate debt. There is opportunity there for investors, although they have to be careful and opportunistic,” Smith says.

There is plenty of reason for caution.

The Center on Budget and Policy Priorities says states across the U.S. had to grapple with a combined $160 billion budget gap in 2010 and will face a $140 billion gap in 2011. Newly elected California Governor Jerry Brown is slashing spending to restore fiscal order in a state with a $28 billion deficit. He has said he won’t raise taxes without voter approval, meaning that budget cuts are the first priority.

The city of Chowchilla, in California’s rural San Joaquin Valley, already has defaulted on a municipal bond issue, and there is a fear that larger towns and cities in California could follow. The town of Central Falls, Rhode Island has turned its finances over to a receiver, and Harrisburg, Pennsylvania averted a default only with the help of a state bailout. Jefferson County, Alabama went into technical default on its debt in 2008, after having run into trouble in the derivatives market.

In New York, Governor Andrew Cuomo took office this month and froze pay for public employees to tackle the state’s budget deficit, now at $14 billion. It could reach $47 billion over the next four years, according to some forecasts.

And then there is Illinois. It arguably has the worst finances of any state. Its $15 billion deficit may not be the largest, but it is still funding operations with debt, which is a worry. A major tax increase is in the works, and state is paying a record yield on its taxable debt, now about 6.25 percent. Non-taxable yields are rising, too.

The burden of closing these budget gaps will fall on state and local governments. Federal Reserve chief Ben Bernanke and GOP leaders said this month that state and local governments should not expect a federal bailout—the Fed will not bailout the states in the manner that the EU has bailed out troubled sovereign issuers in Europe. At least that is what it is saying for the moment.

Smith says he doesn’t expect a huge wave of defaults. “There will be a handful of smaller municipalities that will need help, but I don’t expect a wave of them, and I don’t expect states to default. The process in California will be very important to watch. That may be a guide to what happens elsewhere,” Smith says. And he believes that investors can profit from the stress by buying tax-exempt bonds that are secured by first-lien dedicated tax revenues. He thinks general obligation bond can be a good value too, as long as investors can avoid the most troubled states.

The biggest toll, he says, could be economic. As states and municipalities get their budgets under control, they will cut back on infrastructure projects and public spending—usually an important driver of economic growth.

Over the long run, however, the problems could get worse. Warren Buffett has warned repeatedly over the last year that the U.S. faces major problems in the municipal bond market, although the day or reckoning may be five or even 10 years in the future.

If that is the case, municipalities could be stuck with higher rates for years—and that is hard time.

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