States in Tax Trouble: Are Munis in Danger?

Wednesday, June 24, 2009 10:25 AM

By: Julie Crawshaw

An expert acknowledges more local bankruptcies are probable in California, but he points out that since 1983 the total of municipal bankruptcies is only about 200 — and almost none were local governments that were big enough to have muni bonds outstanding. (David McNew/Getty Images)

A severe, widespread drop in personal income tax collections spells serious fiscal trouble for many communities, according to a new report from the Rockefeller Institute of Government.

Less taxes increase the risk that states will need to make mid-year budget cuts, raising the possibility that local governments might not meet their debt obligations — including payments their municipal bonds.

State personal income tax collections fell by 26 percent, or $28.8 billion, January through April 2009 compared to a year earlier. Thirty-four of 37 reporting states saw declines, the institute reports.

Meanwhile, estimated payments and income tax returns dropped by more than 30 percent in the same period, while withholding dropped by 6.9 percent.

It’s likely that states will be forced to consider further spending and revenue actions in 2010 and to confront large budget gaps when federal stimulus assistance ends in 2011, suggest the report’s authors.

How much added risk does this mean for municipal bond investors?

It depends on what kind of bonds you hold, and how long you hold them, say experts. If not defaults, they warn, the market for bond sales will be weaker for some time.

It’s important to protect yourself now: Several types of muni bonds that are responsible for most defaults, they say, and these types are easy to avoid.

From a buy-and-hold perspective, muni bonds still look pretty darn safe.

"There’s no evidence yet that we’re going to see widespread defaults,â€