By Joe Mysak
May 30 (Bloomberg) -- Municipal bond investors should brace for a bumpy ride.
As an asset class, municipal bonds are the sleepiest of investments -- they're safe and they provide their owners with a stream of tax-free income. Prices hardly ever move. That's all you need to know about them, right?
Think again. The news coming out of Michigan, Texas and the nation's capital is all cause for concern, short-term, medium- term and long-term.
This isn't to say that states and municipalities are all going to start defaulting on their obligations. Not at all. Tax- backed municipal bonds will remain the safest of investments.
Moody's Investors Service earlier this year gave some people pause when it revealed that almost all states would be rated Aaa if you ranked them realistically -- that is, if you graded them according to their actual likelihood of defaulting.
Safety isn't the issue. The smooth ride is.
Traders like volatility, prices going up and down. Something tells me they will have lots of opportunities in the days and months ahead in the municipal market.
Bleak Outlook
Consider Michigan, victim of the U.S. auto industry's travails. The state's credit rating was lowered by Standard & Poor's for the third time since 2003 last week, and the rating company said more bleak news was ahead: ``the state could struggle with fiscal imbalances even beyond 2008.''
Back in February, the state's bipartisan Emergency Financial Advisory Board said the state faced a ``fiscal train wreck,'' and you know what? They were right. The state's politicians are still trying to figure out how to balance the budget, which has holes in it totaling almost a billion dollars.
Standard & Poor's wasn't optimistic last week: ``Further downgrades are possible without economic stabilization and real action to restore fiscal balance.''
That doesn't sound good. And don't think this is just going to affect the state's bonds -- oh, no, there will be lots of fallout. In situations like this, there's always plenty of pain to go around, as the state cuts the amount of money it sends around to various jurisdictions.
Michigan is a relatively short-term problem, and one generally confined to its borders.
If you want to worry at greater length, consider what happened in Texas.
GASB Revolt
Last week, the state's legislature passed a law allowing the state and its municipalities to weasel out of a Governmental Accounting Standards Board rule requiring them to calculate how much they owe retirees in so-called other post-employment benefits. The legislation is now sitting on Governor Rick Perry's desk.
This is a problem whether the governor signs the law or not. If he does sign it, be prepared for a two-tiered market. That is, bonds of issuers who comply with the GASB rule, Rule 45, would trade one way, and bonds of issuers who don't would trade another way. It will prove more expensive for issuers who opt out to borrow money.
If the governor doesn't sign the bill, or if he vetoes it, this is still a problem. How many other politicians will be emboldened to introduce similar legislation, allowing their own states or municipalities to thumb their noses at GASB?
GASB 45 is being phased in. The smallest municipalities aren't required to fulfill it until the end of next year. If you are looking for a medium-term worry, and one that goes beyond one state's borders, this is it.
Supreme Court
Of far more concern is the U.S. Supreme Court's decision last week to consider Kentucky's lawsuit against bondholders who contend that the state's policy of taxing bonds sold by other states is discriminatory.
Most states tax the interest on bonds sold by other states. A few even tax their own bonds.
There's nothing predictable about this case, Kentucky v. Davis. Some observers took comfort when the court ruled on April 30 that local governments could direct trash haulers where to take their garbage. The court upheld so-called flow-control, saying it didn't discriminate against interstate commerce. In other words, states and localities can regulate activity in the performance of a traditional public function. Maybe taxing the bonds of other states is just a similar form of permissible regulation.
That would be good news for the status quo in Muniland. But there's no guaranteeing that the court will link the two. The court will consider the Kentucky matter during the nine-month term that begins in October, so we all will have a long time to think about it.
How about this scenario? If the court rules that Kentucky and other states are discriminating against interstate commerce by taxing the interest on the bonds of other states, then the states have a decision to make. They can either stop taxing that interest, or tax all interest. Which do you think is more likely?
I see lots of volatility in your future.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Joe Mysak in New York at jmysakjr@bloomberg.net
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