With rising taxes and poor stock returns many investors are moving to muni-bonds for ‘guaranteed tax free income’ no matter how poor the yield. That may not be wise. In Muni Forecast: Lots of Clouds Allan S. Roth reports:

In an interview, Rauh noted that when you also combine municipal and county unfunded liabilities and update to today’s interest rate environment, the unfunded liabilities amount to $3 trillion to $4 trillion. MIT economics professor Robert Merton, a Nobel laureate, was quoted in the Financial Times as saying that $4 trillion is a minimum amount. By comparison, the total value of issued muni debt is $3.7 trillion, according to the Securities Industry and Financial Markets Association.

In a 2011 paper, Novy-Marx and Rauh estimate that, without policy changes, contributions to government pension plans would have to increase by a factor of 2.5 from their current levels for the systems to be fully funded within 30 years, a common goal.

 The easiest way to achieve this goal is to experience a decade of strong stock performance. The weak stock performance since the turn of the century is partly responsible for the current shortfall. In fact, an 8% geometric annual return is being assumed by public pension plans, and a return of that size seems a bit aggressive, given the low rates now being earned on fixed-income investments. The implication is that it would take double-digit annual returns on stocks to get public pension plans out of their mess.

Rauh estimates that, even if public pensions increase funding levels, some are likely to run out of money in 10 to 20 years, when annual payments will rise to more than $300 billion.

COUNTING ON STOCKS

Despite Whitney’s prediction of a near-term disaster, it will probably take a decade or two to test whether states and municipalities can meet their obligations to both retirees and bondholders. The biggest single factor in the interim will be stock market returns. If the market has another decade like the 1990s, then much will be well again. But if there is another Lost Decade, the stress on municipal bonds will be extreme. Corporate bonds may even be safer than munis, since most corporations have either eliminated or greatly reduced their defined pension liability.

We recommend including bonds in your portfolio in order to provide 5-7 years worth of safe spending. Bonds are for safety. If the safety of muni-bonds is dependent on ten years of double digits of stock market returns, that isn’t very safe. Why not just invest in stocks and hope for the best?

Allan S. Roth recommends placing “taxable bonds in a client’s IRA before considering muni bonds elsewhere in a portfolio.” He also warns against buying individual muni bonds because of (1) high spreads (2) interest rate risk and (3) lack of diversification.

His advice to planners: “Consider limiting your clients muni bond portfolios. Taxable bonds may be a safer choice.”

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