Still, declining yields are a problem for many retirees. In 2002, a 10-year "AAA" muni bond offered an annual yield of 4%, which means a $1 million investment once produced a tidy income of $40,000 per year. "Fast-forward to today, and the yield on a similar high-quality bond is about 1.90% or $19,000 a year," says Sherman. "The investor is asking: Where am I going to find yield?"
The quest for yield can be measured in the flood of cash into high-yield bonds at the rate of $210 million a week, notes James T. Colby III, Van Eck Global's chief municipal strategist. But it is a little worrying that, according to investment bank underwriter Siebert Brandford Shank & Co., five of the six states catching the most fund flows in June were some of the largest debtors struggling with unfunded obligations: New York, New Jersey, California, Florida and Illinois. (In 2010, New Jersey was the first state to be sued by the SEC for hiding its true financial condition from bond investors.) On May 31, Colby wrote in his weekly "Muni Nation" column, somewhat tongue-in-cheek: "End of May, don't go away," a twist on the popular equity market advice, "Sell in May and go away." It was a subtle suggestion that you shouldn't take your eye off your muni investments.
"There's going to be still good demand for munis and the relative value that munis represent versus other asset classes," says Colby, who manages five Van Eck muni ETFs. They look good, he says, next to high-volatility equities and low-return money market funds. "The question is, what do you do for yield, where do you go?" The Market Vectors High-Yield Muni ETF he manages (HYD) had a 12-month yield to date of 5.21% as of July 30, according to Morningstar.
Municipal revenues have been depressed by falling real estate values, especially in California, Arizona, Nevada and Florida, notes Citi's Foux. "But real estate is stabilizing and is a much smaller part of the economy anyway," he says. "On the local level, there may be some credit events, distress situations such as Scranton's parking authority, Detroit and Providence."
Foux's examples are an eye-opener for investors considering muni revenue bonds, which are generally regarded as less risky. The Scranton city council on May 31 refused to transfer $940,000 to the parking authority to help it make a bond payment due June 1. The city reversed itself the following week and the bond payment was made, but not before Bank of New York Mellon, the bond's trustee, threatened to take over the authority's garages. According to news reports, the transfer satisfied the immediate problem, but the authority appears to be limping along payment to payment.
Since revenue bonds generate their own bond payments, such as parking fees in this instance, they are often preferred over general obligation (GO) bonds, which rely on government budgets. Bond buyers also prefer issuers that place their bond debt outside of tax spending caps.
Despite revenue flow, the Detroit Water and Sewerage Department is having problems bringing a $500 million debt issue to market in the midst of a dispute with the state that threatens to bankrupt the city. The risk could push yields up if the bond issue, whose proceeds are needed to unwind numerous derivative instruments hedging $1.4 billion in sewer debt, gets to market.
All three major muni bond rating agencies downgraded Providence, R.I.'s GO and revenue-related bonds this spring to just above junk bond status. An S&P analyst called the city's budget "structurally imbalanced."
In late June, Moody's slashed the ratings on $11.6 billion in California tax-allocation bonds to junk, lowering bonds rated "Baa3" or higher to "Ba1." These bonds had been tied to the state's redevelopment agencies, known as RDAs, that partnered with developers for projects in troubled areas and used property tax money. These agencies were dissolved by the state, and Moody's cited its concerns about whether RDA bondholders would be paid on time while the agencies were being unwound.
But on the whole, muni bond defenders, who have only grown in ferocity after bank analyst Meredith Whitney made her dire 2010 forecast of 50 to 100 municipal defaults, insist California is still an anomaly. Foux also asserts that, unlike some cities, state governments have seen their tax revenues improve overall. And U.S. Census figures for 2011 support him, showing states collected $56 billion in taxes last year, an increase of 9.7%-greater than the 9.2% rise in corporate tax revenue.
(For the record, Whitney meant municipal "default" to include cutbacks in public employee rolls and pension promises. As previously stated, first-time defaults have come down, but 100 were filed for the year ended July 26, 2012.)
As for the flow of tax money into states, it must be viewed against each state's outward flow for ever-expanding retirement payments and health benefits. The latest analysis by the Pew Center on the states, called "The Widening Gap," underscores that not all states are recovering at the same pace, another reason to scrutinize each issuer. Pew found that the gap between states' assets and their obligations for public sector retirement benefits widened again in 2010, the most recent year available, to $1.38 trillion, up nearly 9% from 2009. In 2000, more than half the states were 100% funded, but by 2010, 34 states had fallen below Pew's 80% cutoff for a healthy pension fund. Only Wisconsin was fully funded. And only 75% of states' pension liabilities were funded. The Pew report singled out Connecticut, Illinois, Kentucky and Rhode Island as "the worst," as all were under 55% funded in 2010. North Carolina, South Dakota, Washington and Wisconsin were the only states funded 95% or better. Note, Pew said that between 2009 and 2011 some 43 states enacted benefits cuts. Those made in 2010 and 2011 were not captured in its report, such as Rhode Island, where cuts in 2011 effectively reduced its unfunded liability by an estimated $3 billion.