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The Securities and Exchange Commission is worried that municipal bankruptcies, 
combined with an expected spike in interest rates, means that the muni bond market could face “Armageddon” with devastating consequences for the individual investors (74% of the total) who hold the paper of which many are retirees. Words: 490
So writes Jake Zamansky (www.zamansky.com) in edited excerpts from his original article* entitled Investors Face Potential Municipal Bond Armageddon.
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Zamansky goes on to say in further edited excerpts:
The Risk
SEC Commissioner Dan Gallagher made his comments last week at an SEC-sponsored fixed income round table discussion. He was immediately attacked by those in financial services industry for making “irresponsible” comments, but his concerns are valid.
According to an InvestmentNews column by Jeff Benjamin (subscription required): “The municipal bond market is quick to point out that defaults are rare and bankruptcies are even rarer but what concerns those such as Mr. Gallagher is the trend of credit quality in the muni bond arena, combined with an environment where rates can only go up, thus driving down the value of existing bonds.”
That argument is compelling. The credit quality for municipal bond issuers is worsening as a general matter, Benjamin noted. “According to Moody’s Investors Service, municipal bond downgrades have outnumbered upgrades for 16 consecutive quarters, which is the longest period that has occurred since Moody’s began tracking the data.”
Fears about munis are nothing new. Banking analyst Meredith Whitney has been warning for some time about impending bankruptcies of municipalities and the impact that would have on municipal bond investors.
Gallagher and Whitney aren’t the only ones warning investors about municipal bond risks. The securities industry’s self-regulating entity, FINRA, issued an investor warning on the issue this past year, but it was not seen by most investors or covered by the media.
The Reward
With interest rates at record lows, investors are seeking return and income from an ever-riskier pool of investments. Investors have jumped into muni bonds seeking higher yields than US Treasuries, and investors also like the tax benefits of most municipal offerings.
The Fear
The fear is that investors may not have been told by their brokers about the “interest rate” risk and the “wipeout” risk should more municipalities file for bankruptcy, as many have already. This is what the SEC’s Gallagher is getting at when he talks about “Armageddon.”
Most retail investors don’t understand these risks and could get blindsided when interest rates spike, as they eventually will, causing the price of muni bonds to crater.
Any exit strategy from the municipal bond market, when interest rates rise, will be very expensive and incredibly difficult. Indeed, investors holding municipal securities could find themselves simply stuck if such a sell-off occurs. Unlike other bonds that are much more liquid-think US Treasuries or high-grade corporate debt-the municipal bond market operates under rules that are pretty much, “You buy it, you own it, good luck getting rid of it.”
That sure sounds like a lot of risk for individual investors holding muni bonds, doesn’t it?
Conclusion
Investors beware. Armageddon for municipal bond holders lies ahead, and it could hit you like an iceberg.
(Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.)
*http://www.zamansky.com/blog/2013/04/investors-face-potential-municipal-bond-armageddon.html (© Zamansky & Associates 2013. All rights reserved. Zamansky & Associates are securities fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.)
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