Repercussions of Meredith Whitney's Muni Bond Default Warnings

Only Monday I was writing of Meredith Whitney's warnings on impending muni bond defaults, putting her publicly at odds with PIMCO's Bill Gross. Further, Whitney explicitly called Gross on the motivations behind his rosy view of such fixed income instruments.

Yesterday on CNBC, Doug Dachille provided his usual scintillating and informative remarks on the fixed income market.

For starters, he agreed with both Gross and Whitney that there will probably not any US state defaults. Dachille then launched into a unique analytic description of how state tax-exempt munis play a part in financing vis a vis tax increases and defaults. Specifically, he noted that most holders of a state's bonds are wealthy state residents, because of the tax exemption. Thus, Dachille noted, a default was as good, or bad, as a tax increase, because, either way, it came out of the same pocket. However, he explained, when a state cut services to fund bond payments, that was essentially regressive, as the state's lower-income residents probably got disproportionately hurt, while the wealthier households continued to enjoy their interest payments without tax increases.

Very interesting insights on income redistribution, taxes, budget cutting and public finance bonds.

Then Dachille told a story that reinforces my belief that retail investors should never, ever, directly purchase bonds. He described a NY city waste treatment plant bond which provided for interest payments before the city was paid its operating expenses. Thus, he noted, the bond was doing nicely at 5+% and had a nearly zero chance of default. But, he cautioned, you had to do your homework to know this. Not all bonds are equal.

Exactly. Which is why when friends talk to me of building bond ladders, I cringe. Unless you are talking very plain vanilla corporates or Treasuries, you're playing with fire. Not to mention the brokerage fees hidden in the spreads when buying individual bonds.

Then Dachille pointed out another important feature of bonds, i.e., with rates so low, and nowhere to go but up, a non-defaulting muni has only its total cash flow as its maximal value. Thus, he said, investors have to realize that muni bonds aren't going to be growth instruments yielding 12% return rates, as equities might.

In sum, he painted what I think is an accurate, often missing picture of fixed income investing as much more risky for retail investors than is generally realized. And why well-managed bond funds serve an important function.