Volume X, No. IV

If you pay federal and state income tax, you've probably considered (or your advisor has recommended) municipal bonds as a great way to get tax-free income with a high degree of safety. But whether you invest in municipal bonds (or muni bond funds) or are considering investing now, you need to ask yourself:

About a year ago, we first addressed the issues surrounding municipal bonds. Here's what we said:

The time has come to kick it up a notch. For the first time, some people who've invested for years in these traditionally safe sources of tax-free income are afraid. With all the financial problems municipalities now face (as we discussed in our letter last month) it's time to ask some tough questions:

• Should you sell your municipal bonds now?
• Could municipal bonds be in worse shape now than they were in the Great Depression?
• Are there ways to hedge your munis without selling all of them?

– with tree pollen readings through the roof (Claretin anyone?). What happens now that May is here? Will May's flowers rise up and eat us alive?

So here's to you Mother Nature. May we never forget your awesome power and beauty. Now if you would just do something about that pollen…

While she's working on that, let's take a moment to point out that, as opposed to nature, the stock market's been pretty sleepy. The traditional measurement of stock market volatility – the so-called "VIX" or "fear index" – settled under 20 and has stayed there for most of the year. Take a look at this chart from Stockcharts.com:

You can see that fear peaked around October 2008 – the emotional height of the financial crisis. Now the VIX is telling us that there's no real fear, in fact hardly any concern at all, out there right now. Relax. Go smell the roses.

As for bonds, we keep hearing about interest rates going up…then not much happens.

Of course, there has been this whole Greek sovereign debt drama playing out as we speak. But it's all so far away, isn't it? It's hard to get worked up about it. Besides, the Greeks practically invented drama over 2,500 years ago. What's the big deal?

Sitting on top of all this, we find a steady flow of good news from economists and the government. Unemployment has stopped going up, house prices stopped going down. Heck, even consumers started spending a few bucks lately. Nothing wrong with that.

The fact is, in spite of all that hype about "volatility" that Wall Street uses to scare you into buying some "safe" product or hiring a new broker right away, markets go through their sleepy times – like right now.

So now that we're all calm, let's take our look at municipal bonds. No, we're not trying to get you all riled up. But here's the thing: the best time to take a good look at something and figure out if there's danger over the horizon is before any problems happen. In that spirit, we'll proceed.

Let's start with those bleak municipal finances. Revenues keep falling while their expenses and obligations keep growing. Cutbacks of services and layoffs of employees have already started. No one really knows where and when it ends.

Still, municipal bonds seem to be holding up pretty well. In fact, if you've been invested in munis, you're probably showing some decent gains in the principal of your bonds right now. The market's not signaling any problems. So why worry? Markets look forward don't they? They discount whatever they see coming, right?

All true. But remember they don't look out into infinity. At best, we're talking somewhere along the lines of three months, sometimes a year or so. And in the business of investing, you learn that when things look good – even more so when things are as calm and sleepy as they are now – it's time to look around and see what might jump up and bite you.

If municipal bonds don't bite us, we think there's a good chance they may at least sting some of us.

Let's remember that municipalities, like much of our economy, got a double shot of strong espresso from federal government bailout money. How long that caffeine rush lasts, we don't know.

Financier Richard Ravitch, now serving as interim lieutenant governor of New York, wrote in the January 8, 2010 Wall Street Journal: "The federal stimulus has led states to increase overall spending…which in effect has only raised the height of the cliff from which state spending will fall if stimulus funds evaporate."

Bailout money's been a two-edged sword. We've mostly seen the dull edge. You have to remember that even the budget freezes and initial layoffs we've seen so far have been tempered by federal stimulus dollars. With that money now spent, we're edging closer to the edge of that cliff.

Of course, muni bonds have been through all this before. In past economic tough times these bonds have held up – with the exception of the Great Depression. Here's what typically happens:

First, revenues fall. If the economy's not that bad, municipalities might even issue more bonds to help them meet the shortfall. It works as long as things don't get worse.

For example, during the 1974 recession things got worse. New York City's revenues weren't even close to meeting their obligations. They tried issuing more bonds, but hit a wall. No one bought. But that turned out to be an exception to the rule.

In fact, if you talk to folks who make their living managing portfolios of municipal bonds, all the defaults that have occurred in the muni bond market were an exception to the rule. We've had this conversation with various municipal bond managers at least three times over the last couple of decades (1994, 2001, 2008). The explanations are always the same.

Municipalities depend so much on their ability to raise money by issuing bonds, they don't want to default. If they do, they'll be "frozen out" of the bond markets – meaning they won't be able to raise money in the future by issuing bonds; no one will trust them.

So how have they dealt with past drops in revenue? They cut expenses and raise taxes. Sure, they whine, they threaten to cut way back on services like public schools, police and fire protection, garbage collection, etc. They scare everyone, maybe buy some time with an occasional temporary freeze on interest payments – but in the end, it all works out.

What about the Great Depression? Well, things were certainly worse then. There were outright defaults in addition to some deferments in interest payments. But municipal bond managers will tell you that things weren't that bad and markets returned to normal pretty quickly.

Okay, let's accept that assessment. If we do, then there's no real problem. Keep your munis. Buy more. The storm will pass. No way municipalities will allow large-scale defaults. They'll cut, they'll raise taxes, they'll do whatever needs to be done to make sure that – with maybe a few exceptions – interest gets paid to their bondholders. They'll even be able to raise additional money by issuing new bonds, if they need to.

That's the good news. Of course, there's another side of the story.

Don't worry – yet. We didn't write this headline. It's from a controversial piece written by Frederick J. Sheehan for welling@weeden, an investment research firm.

The author recognizes that muni bonds have survived some tough times, including the Great Depression, as we noted above. Admittedly, he's not as sanguine about the Depression as the muni bond managers we've talked to. But it's not what happened during the Depression that's got us concerned. It's the idea that the problems we're seeing now have been building up for a long time. Last month, we made a similar point: municipalities have successfully covered up their financial problems for decades. So the natural question is:

For at least 30 years, cities and states have been able to kick the can down the road. With lower and lower interest rates since 1980, re-financing existing debt could lower interest payments and even leave room to issue more bonds.

But what about now? Interest rates are at historic lows. There's not much room for them to go down anymore. That's a red flag. In addition to that, here are some other reasons to be concerned that municipalities may have reached their limit:

• Taxes have never been so high.

Property, school and sales taxes are simply much higher today than ever before. Will municipalities really be able to raise local taxes even more? Remember that unemployment remains close to 10%...17% if you count the "under-employed" and those who've given up trying. Will state governments help out? They have before. Except that in past crises, states didn't face health care obligations like Medicaid along with a decaying infrastructure. Think about it: back in the Depression a larger percentage of people were younger; roads and bridges were just being built, not falling apart.

• Municipal employee retirement packages have never been so rich.

We've always had municipal employees – but not with the pension and benefit packages you see now. It wasn't until the 1960's that municipal employee unions were permitted by governments. Before that, they were illegal. Why the change? Simple. Politicians thought unions would bring out the vote. Surprised? With the unions came more aggressive, binding arbitration and richer pension and benefit packages.

Ironically, at first the justification for rich municipal employee benefits – pensions, medical benefits, vacation, etc. – was that these folks made less than folks that worked in private industry. Now that's changed. Government workers, including many municipal employees, make as much and even more than other workers. In fact, government employees now make over 40% more than folks in private industry. Times have changed.

• The federal government may not be able to step up to the plate like it did in the past.

We wouldn't bet against the federal government riding in on a white horse at the last minute. But, again, things are a lot different now than they were even back in the Great Depression. Think: deficits and debt.

If the federal government does answer the call, its deficit will balloon to even more unmanageable levels – along with the national debt. Remember, the government has no money set aside to help out. It's sinking more and more into debt with no relief in sight. This sort of aid to states and municipalities isn't included in current budget projections – projections which already have the federal deficit at levels some call dangerous: $1.556 trillion in 2010, $1.267 trillion in 2011. And some experts believe these are understated. For example the real deficit in 2009 was $1.9 trillion, not the $1.413 trillion originally projected.

This doesn't even count those unfunded liabilites (e.g., social security and Medicare) which stand somewhere between $58 trillion and $75 trillion. Do we really want the federal government stepping up to the plate and piling on even more debt?

Then again, you can just see political pressure build as the cuts in services and layoffs add up. With that in mind, we can easily imagine federal aid of some sort at some point. Besides, the world didn't end after the recent multi-trillion dollar bailout packages of the last couple of years. Why should it end now?

Conclusions:

Well, we don't want to forget the three questions we posed at the beginning of this month's letter:

• Should you sell your municipal bonds now?
• Could municipal bonds be in worse shape now than they were in the Great Depression?
• Are there ways to hedge your munis without selling all of them?

A decision to sell out your bonds should be driven by your individual circumstances. Remember that you should always balance risk and return for any investment. So answer the question: is the tax-free return worth the possible risk to interest and principal that may plague municipal bonds if things continue to deteriorate? (By the way, there's currently a move in Congress to change the rules and make you pay tax on municipal bond interest in the future! After all, they do that in other countries.)

As for any comparison with the Great Depression, we've already pointed out that back in the 1930's, we had lower overall debt, fewer municipal employees and a federal government that wasn't the debt-laden basket case it is now. Ask yourself, if we get continuing deterioration of municipal finances: How many people can you lay off? Where do you draw the line at reducing services? Will existing and future union retirees accept lower pension benefits in addition to fewer current benefits? (When did this ever happen before? Not in our memory.) And how much can the federal government really provide? As it is, they're already looking to raise income and other taxes – on more than just "the rich" – just to keep their heads above water.

So what if you don't sell all your bonds now, but you're still concerned about increasing risk to interest and principal? Is there any way to protect yourself?

The short answer is yes. You can look at taxable sources of income – although it's not like there's a long list of safer alternatives out there. Still, there are some reasonable ideas you might look at. Try dividend-paying stocks, a few REITS (but you've got to choose carefully – most of these are too pricey), oil and gas trusts (again, choose wisely).

One last point: What happens if people do start dumping their muni-bonds? We really can't predict whether that's coming or not, but remember this. As the governments (federal, state, and local) raise taxes, the tax-free income from muni-bonds becomes more attractive. People may continue taking their chances with muni-bonds for that tax-free income (assuming it remains tax-free) even in the face of increasing risk.

On our end, we're looking to hedge our bets. Muni bonds certainly look sicker than they did last year. We simply don't see a way that frail municipal finances get stronger again – not for a long time. We'd rather not wait around to see what happens. If we reduce our exposure, we might pay a few dollars more in taxes. Then again, there are other ways to address taxes besides municipal bonds. We'll certainly be more active in taking advantage of any and every opportunity to reduce risk without increasing our tax liability. It's all part of good, thorough planning.

One thing we will keep our eyes on – and this will be our final thought for this month – is those federal deficits – specifically the ratio of deficits to expenditures. We're almost at 40% deficits vs. expenditures now. Historically, deficits at this level mean inflation. Left unattended, you can add a "hyper" to that inflation.

Well, we did start our letter with the observation that things have been relatively calm. We hope our letter didn't raise your anxiety level. But in case it did, here's some comic relief from Christopher Walken filling out his census form.

Ever since his debut in the great movie "The Deer Hunter," we've always thought this native New Yorker (Astoria, Queens) was a highly talented – and very strange – actor. These two traits come together nicely in this skit about the census. Take a moment and see if you don't laugh out loud. Oh, and we hope you've sent in your own census form by now.

Here's the link.

See you next month!

P.S. – Next month, we're planning to look at the real estate market. Are things turning around? And even if they're not, is it safe to buy now? We'll be putting together some ideas on how to know when real estate is worth your hard-earned money. Until then, you can check out my personal blog. Recent posts include: What Regulatory Reform Needs To Address, How Banks Hide Their True Financial Condition and a cautionary tale about the Shocking Fees That Just Hit My Bank Account. As for that last item, better go online now and make sure this isn't happening to you!

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com