Is Meredith Whitney Right on Municipal Bonds?

Meredith Whitney Municipal Bonds The banking analyst Meredith Whitney has been predicting a crash in the municipal bond market owing to the weak state of municipal finances.

Meredith Whitney has her own advisory firm, and performs research on the equity and bond markets. She became well known through the accuracy of her downbeat predictions of the state of bank finances before the 2008 financial crisis and is now taking an equally gloomy view of the financial state of many US towns, counties and cities.

Whitney frequently appears on the major TV channels to air her pessimistic views on municipal finances.

If Whitney’s views are correct, the future could hold a tidal wave of municipal bond defaults. In her view, State finances are growing worse and the problems are much greater than reports from commentators and credit rating agencies would suggest.

There are basically three reasons for Whitney’s view of the hidden problems within State finances.

Pressures on State finances

1. State Spending has been rising during the recession.

Firstly, State spending has continued to rise during the recession while the income from taxes has not risen. This gap between income and spending has been partly covered by Federal government grants and contracts under the economic stimulus legislation but much of this is coming to an end. The States have also had to call on their reserve funds retained for hard times or the surpluses kept for emergency situations, which are now being rapidly depleted.

2. States have issued more debt which in turn, leads to more pressure on state budgets.

Secondly, the States have had to issue more General Obligation Bonds to cover their operating costs. These bonds are generally backed by a pledge to cover the cost of servicing the debt by increasing State property taxes if necessary and are normally given a good credit rating. Although defaults are therefore unlikely on these bonds they still put additional pressure on State finance and increase the interest burden.

3. State budgets have been increasing outlays to cover pensions of retiring municipal workers.

Thirdly, the cost to the States of pensions is adding hugely to the burden. The States are not adequately funding their pensions and are therefore creating a pensions time bomb that will increase the need for State spending on pensions in the future. This means that the need for additional tax revenue or spending cuts in other areas of State finances will be greater than currently predicted. Effectively, liabilities for payment by States of future pensions and other post employment benefits amount to a huge off balance sheet debt that spells hidden trouble for the States and municipalities.

The main danger of default comes from Revenue Bonds.

These are issued to fund particular capital projects such as roads or housing projects. They are not backed by any guarantee from the State but depend on the flow of income from the project to service the debt. If the income is not sufficient to cover costs of the project, there will be a need for the debt to be restructured and investors in the Revenue Bonds will lose out.

Meredith Whitney’s Full 60 Minutes Interview:

Summary of Meredith Whitney’s full video:

Here is a link to a video from CNBC of the counter argument to Meredith Whitney’s Position on Municipal Bonds

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Comments

  1. Gma says

    I would avoid muni bond funds at all costs. Given that muni bonds’ yields are geanlerly seen as less risky than corporate bonds (even in light of municipalities’ shaky finances) the yields offered on muni bonds are geanlerly paltry (though, this is mitigated to some extent by their tax-advantaged status). However, the fees inherent in investing in bond funds (or any other type of fund) eat into returns, along with the standard burdens of both inflation and taxes (again, here, taxes may not be an issue). So, with muni funds you have at least to burdens that will retard your return: the fees you pay to the fund manager, and inflation.Better to buy munis directly, as others have mentioned. Also understand that if the munis throw off interest payments, your yield to maturity will likely be less than the stated yield because the YTM calculation naively assumes you can reinvest the dividends and achieve an equal rate of return (this is termed reinvestment risk, and is an important part of the risk profile of any bond analysis.)(I just got through studying bond valuation for the CFA exams, so all of this is top of mind right now.)

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