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These Munis Are Junk Bonds In Disguise

These Munis Are Junk Bonds In Disguise

Interest in muni bonds is heating up with marginal income tax rates set to rise in 2011 and imposition of a 3.8% Medicare tax on investment income beginning in 2013.

Given their combination of favorable tax treatment, relative safety and muted volatility munis have long been a favorite investment of taxpayers in high tax brackets.

Just how safe are munis? Historically they’ve been viewed as bulletproof. High profile defaults such as NYC in 1975, Cleveland in 1978 and uber-wealthy Orange County (CA) in 1994 make headlines but by and large munis have an extremely low default rate.

Is this about to change? Could be.

On the income side the economic slowdown has crippled the tax receipts of many states. Spending requirements continue to rise as Uncle Sam pushes additional burdens down to the state level. The final nail in the coffin is, unlike the Federal government, states are required to annually balance their budgets. Increased debt burdens have long been preferred over spending cuts but many states have gone the way of Greece and are tapped out.

And so with a nod to David Letterman here’s a “Top Ten” of states with the strongest likelihood of default:

There’s a double whammy here. Not only does the state rely heavily on an auto industry on life support but the government has for years failed to diversify the economy. Special tax breaks to the film industry and Jeff Daniels’ TV spots promoting the state as business friendly are a far cry from a meaningful attempt. It smacks of too little too late.

The beauty of the Pacific Northwest is offset by its economic reliance on timber. With home construction taking a serious post-bubble hit so did Oregon’s tax receipts.

The poster child for when good intentions lead to bad outcomes. Tax reform of a few years ago brought about a flat income tax. That’s good. Unfortunately the sales tax is skewed towards manufactured goods which hurts because the services sector is (a) larger and (b) growing faster.

The perfect storm – a state heavily dependent on migration and tourism has been battered when home construction collapsed, real estate prices plunged and nationwide unemployment jumped to 10%.

Score one for Midwestern values. The state permits a rainy-day fund contribution of up to 5% of annual tax receipts. Unfortunately The Badger State has been hit so hard the past few years have seen outflows from rather than inflows into this account.

Ah, The Garden State – home of the refinery, the traffic jam and the “what exit?” method of finding out where your friends live. This historically free-spending state lived up to its reputation under John “I used to run Goldman Sachs so you can trust me” Corzine by publicly and very loudly allocating $650 million of last year’s budget to retire debt…while quietly authorizing close to $4 billion of new debt for school construction. The state’s long-term debt burden currently sits at just short of $50 billion.

Nevada like Florida relies heavily on migration so it too suffered when real estate prices headed south and home construction collapsed. Whereas Florida got the double whammy of vacationers staying away from Disney Nevada watched as gamblers steered clear of Vegas. On top of it all the Obama White House waged war on companies hosting conferences in Sin City.

The problem here is similar to those in Florida and Nevada – home construction and real estate prices. What’s more Arizona gets roughly half of its revenue from sales taxes so frightened consumers who don’t spend don’t contribute to state coffers.

The Land of Obama…er, Lincoln…is so well-run that this past summer the state legislature sent the governor a budget with a built-in $1 billion deficit. Good idea – shirk responsibility and let the governor balance it.

Where to begin? Yes the state has a diversified economy but it also has punishing income tax rates and so many Propositions voted into law that 80% of the annual budget is non-discretionary. Ouch. Double ouch.

Caveat emptor!!

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