Decline in state tax receipts, demand for social services put strain on states’ budgets

Many investors don’t realize that we are swimming in uncharted waters. Because the tremendous dislocation caused by the 2008 financial crisis will take years to recede fully, don’t let the recent relief rally in equity markets lull your clients into thinking that we are in a sustainable bull market.

Risk to capital remains high, although the market may have fooled many investors into thinking it has abated.

Powerful cyclical rallies are typical after significant corrections and are usually based on improving news, but they are rarely supported by improving fundamentals. For a secular bull market to emerge, economic growth must be supported by rising corporate revenue and earnings.

So far, earnings gains are due mostly to cost cutting.

Ominously, a looming crisis that has not yet been addressed exists within state and municipal budgets. According to the Center on Budget and Policy Priorities, a non-partisan group focusing on the needs of low-income families, the worst decline in tax receipts in decades has created unprecedented fiscal problems for states.

These revenue declines show no signs of letting up, and the center expects the current recession to be more severe than the last one, causing state fiscal problems to be deeper and more persistent than in previous recessions.

At least 48 states have budget concerns, with shortfalls estimated at $168 billion for the 2010 fiscal year. At least 36 states already anticipate significant deficits for 2011, with total budget shortfalls estimated at an additional $180 billion.

Many economists expect unemployment to peak well above 10% in 2010, which is significantly higher than in the last recession. With fewer people working, states will likely experience falling income tax receipts coupled with increased demand and expense for social services.

During recessions, consumers tend to spend less. This causes sales-tax receipts to fall dramatically. When combined with falling property tax receipts due to rising delinquencies and defaults on residential and commercial properties, the decline in state and municipal revenue may continue for some time.

These unprecedented fiscal problems should give pause to municipal bond investors.

Until now, the municipal bond market has completely ignored the risk of default. The historically low default risk, at an average 1.5%, has lulled many investors into a state of complacency. We find this eerily similar to the historically low 3% default rate on residential mortgages right before residential-mortgage-bond pricing hit the skids.

Mortgage defaults subsequently soared to levels not seen since the Great Depression, taking down some of the largest financial institutions in the world, and defaults are still rising.

In the face of the financial crisis and California’s budget problems, municipal bond prices fell by approximately 20% in 2008. Pricing recovered last year and, once again, many bonds traded at a premium.

It is baffling that prices have recovered when budget problems persist despite the deepest expense cuts by states and municipalities in history.

Whatever the cause, this is one of the best selling opportunities municipal bond investors will ever have.

This is a very rare win-win investment opportunity, as we expect muni bond prices to fall materially due to the increasing likelihood of bond defaults or the federal government moving too slowly to bail out troubled states and municipalities. (The current political climate does not seem to support even-greater federal deficits.)

The anticipated muni bond price collapse would cause yields to rise dramatically, presenting a once-in-a-lifetime opportunity to buy cheap tax-free bonds with extremely high yields.

To take advantage of the opportunity to buy low, investors in municipal bonds must sell before prices decline.

Investors may have to pay some tax. However, they can do so at the present capital gains tax rate, which is likely to rise significantly by next year.

Even if prices do not fall precipitously, it is extremely likely that inflationary pressures will cause interest rates to rise, which means that bond investors are still better off selling at today’s prices.

Investors who depend on muni bonds for income are advised to set aside a one-year reserve while they wait to reinvest.

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20100103/REG/301039991/1005/INVESTMENTSTRATEGIES

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