And state governments are feeling the pinch. According to the National Conference of State Legislators, there are only three states (Arkansas, Wyoming, and North Dakota) that do not face budget shortfalls for fiscal years 2009 or 2010. In other words, 47 states are currently projected to run short on cash in the near future.

And California – the world’s eighth largest economy – is in the worst shape of all. Currently, the state has committed to spend $26.3 billion beyond what it takes in. Controller John Chiang estimates that the state has enough cash to last through July. To avoid defaulting on debt payments, California will issue more than $3 billion of IOUs this month.

But while the plan may buy some time, it will only make the situation worse. The big banks (Bank of America -NYSE:BAC-, Citi -NYSE:C-, Wells Fargo -NYSE:WFC-, JP MorganChase -NYSE:JPM- and others) have stated that they will not cash the IOUs after July 10th. On a side note, this likely means that the banks are either so short on liquidity that they can’t afford to do so, or they are not confident that the state will honor its commitments when the IOUs mature in October.

That means that the state’s contractors and vendors must either hold these IOUs until they mature, sell them at a discount in the secondary market (listings are already popping up on Ebay and Craigslist) or, for smaller denominations, take the hit at a check cashing store.

Many of these contractors are already strapped for funds to pay their employees and subcontractors and can ill afford the disruption in cash flow. Undoubtedly, this will cause a cascading domino effect of layoffs, defaults and business closures. This will depress tax revenues even more, while increasing the demands for government services.

And it is not just contractors and vendors taking a hit. Local governments are also receiving IOUs for the state’s financial obligations. That could force some local governments to default on their municipal bond payments.

But this is not what constitutes the greatest threat to municipal bondholders nationwide. That threat comes from the federal government.

You see, state governments are not permitted to run budget deficits. Unlike the federal government, state governments are required by law to balance their budgets each year. And they can’t just print money like the federal government does (California’s quasi-legal IOUs notwithstanding).

That means the states must either cut services, raise taxes, or both. Neither alternative is easy to get through the legislature. In the case of California, Schwarzenegger recently declared that tax increases are “politically impossible.” And yet the alternatives include slashing spending on health care and education and releasing inmates from prison.

Political difficulties aside, California and just about every other state will be cutting services. And you can guarantee that just about every tax you pay will be going up in the future. But the states will also be putting increasing pressure on Washington for handouts. If there was money for the banks and the car companies, certainly there must be something for the states, right?

So far, Washington has rebuffed California’s calls for bailout money. The aid they have issued has come in the form of stimulus, such as increases in Medicaid and education funding. But the stimulus is obviously not working, and it’s not just California that is in trouble.

Corina Eckl, Director of National Conference of State Legislators, recently wrote, “The state fiscal situation is rapidly deteriorating and the figures for fiscal year 2009 and fiscal year 2010 have moved from sobering to distressing”. She compares the situation to a bad horror movie, where the “details get more gruesome, and the story never seems to end.”

As the cries for help become more urgent, the possibility grows that Washington will come to the aid of California and other states facing serious shortfalls. But don’t think for a moment that this assistance will come without strings. And one of these “strings” could well be the elimination of the tax exemption on interest payments from municipal bonds. In fact, the Obama administration has already pushed us over that slippery slope.

The interest payments on state and local bonds for public projects have always been exempt from federal taxes. But since the FDR administration, various presidents and legislators have tried to remove this exemption.

Given the “tax the rich” mentality in government, and the fact that nearly 50% of tax-exempt bond income is claimed by households earning over $500,000, it’s no wonder that efforts to roll back the exemption have grown stronger. And the “extenuating circumstances” of the current financial crisis have provided just the cover that was needed.

As part of the “American Recovery and Reinvestment Act of 2009” state and local governments are now authorized to issue taxable “Build America Bonds” to finance projects for which they could otherwise issue tax-exempt government bonds.

State and local governments that issue these bonds would “receive a federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35% of the total coupon interest paid to investors.”

And because there was no hearing on these bonds, there was no opposition. Investment manager, Richard Shaw of QMV Group, calls this the proverbial “camel’s nose under the tent.” Before long, the entire beast is sleeping right beside you. It was enough for Bloomberg to state that, “Barack Obama may be the worst thing that ever happened to tax-exempt bonds…”

Now, you might be saying that issuing new taxable municipal bonds is a far cry from re-writing the rules on existing bonds. And I would say the same thing, if it were not for what happened recently to bondholders of Chrysler and General Motors.

In both cases, once the government got involved the contractual rights of capital were superseded by the “greater good of society” – a blatant violation of contractual law and more than a thousand years of common law. Chrysler bondholders were denied first priority in liquidation. And GM bondholders were shafted in favor of the union.

I am not saying the rules will be re-written for municipals. But I wouldn’t rule it out either. If the federal government intervenes in state finances, you can be sure there will be strings attached. And one of them could involve an assault on tax-exempt income.

Quoting Richard Shaw again: “If the federal government steps in to provide ‘exceptional assistance’ to California or any other state, it would be imprudent to deny the possibility of the rights of bondholders being subordinated to the ‘greater good.’”

Considering the tenuous state of state and local finances, the risk of default on municipal bonds is almost certain to increase. Add to that the outside potential for a change in tax status and caution is advised. If you own municipal bonds, diversification is paramount. And stick to general obligation bonds, which are backed by the full taxing power of the issuing jurisdiction.

And don’t forget, banks and Property & Casualty insurance companies own about 25% of all municipal bonds. So, if the municipal bond market takes a hit, these sectors will suffer the consequences. Invest accordingly.

P.S. My colleague, Steve McDonald, runs an exceptional service called, The Bond Trader. His focus is on high quality, investment grade corporate bonds. According to Moody’s the long-term default rates on these bonds are less than 1%. And because Steve only recommends bonds trading at a discount, he has led his subscribers to capital gains as high as 84%, combined with super-safe income.

Since September, 59 out of 62 of Steve’s recommendations have increased in value… two are breakeven and only one is down. Compare that to the stock market and you might wonder why you’re taking such a big risk in stocks. Learn more about The Bond Trader here.

Source: Will the Feds Use the California Crisis to Change the Rules on Munis?

• Who took short-term rates to the cellar, creating a massive incentive for consumers and investors to borrow?
• Who gave real estate investors a $500,000 tax exemption on their profits from flipping houses every two years?
• Who passed laws criminalizing banks’ failure to lend to subprime borrowers?
• Who set up quasi-government institutions Fannie and Freddie … to warehouse those bad mortgages, leaving taxpayers to pick up the tab?

You got it… The same people who are now howling about how the ‘free market’ (such a thing hasn’t existed for quite some time) got us into this mess.

Alex says Team Obama’s spending plans and its hostile takeover of what’s left of the free market mean the middle-class can expect their taxes to “go higher… a lot higher.”

Alex, for those of you who don’t know him, is the chairman of InvestmentU.com and the investment director of The Oxford Club, an index-beating network of private investors and entrepreneurs.

He says the best way to combat higher taxes is to invest in tax-free, municipal bond funds. Here are three solid reasons why you should consider tax-free munis:

1. Ten-year municipal bonds, while down from the historic premium they reached a few months ago, are yielding as much as 10-year Treasuries. Treasuries are taxable. Munis are not.
2. Most municipal bonds are safe. Yes, a few areas – particularly in California and Alabama – are troubled. But the historical default rate on municipal bonds is just 0.3%.
3. Taxes will soon be going higher. A lot higher.

Alex recommends two ways to cash in on tax-free munis. These could be critically important in coming years. As Alex says, “The wild fiscal imbalance is already crystal clear. Washington politicians will soon demand that you sacrifice even more of your paycheck so that they won’t have to sacrifice the near erotic charge – and high incumbency rate – they get from spending it.”

1. Buy them through Vanguard if you are a mutual fund investor. (The average fund company charges expenses six times higher than Vanguard’s.)
2. If you are a closed-end investor, try a tax-free fund like Nuveen Insured Municipal Opportunity Fund (NYSE: NIO) trading at a 10% discount to its net asset value and yielding over 6% paid monthly.
3. Or, to avoid annual expenses and have the certainty of a final value on a particular date, buy individual tax-free bonds.

Alex has uncovered the perfect way to make money in today’s market. It involves ignoring all talking heads on CNBC for the next 45 days.

Just confirm your interest and full address here, and The Oxford Club will FedEx you a $1,500 check. This money is yours to keep. You’ll never have to pay it back.

Alex’s track record so far is outstanding. By following his recommendations from March 9 to March 17, 2009 – one week – you could have tripled your money. And from January 20 to May 5, 2009, you could have turned just $5,000 into $62,968.

But those same investors are starting to unleash a landslide of cash into the markets. According to the April, 2009 Merrill Lynch Survey of Fund Managers, optimism about global economic growth has reached its highest level since 2004, prompting investors to lower their aversion to risk.

The percentage of investors who are overweight in cash in their accounts fell to 28% in April from 41% in March. That’s a significant drop, and it represents a lot of cash being put to work elsewhere.

Those numbers make sense, according to AMG Data. The $3.7 trillion money market fund sector experienced cash outflows of $35.5 billion in February, $51.15 billion in March, $18.7 billion in April and $15.2 billion so far in May.

Why? Investors’ aversion to risk is waning, and they are beginning to feel comfortable again putting money into riskier investments. So where’s all this cash going? That depends somewhat on whom you ask, but the short answer is just about every place it came out of last fall, including municipal bonds.

Gary Baker, co-head of international investment strategy at Banc of America Securities-Merrill Lynch Research, recently remarked, “Improving sentiment on financials has decisively removed the log jam on sector rotation, prompting a march out of defensives into cyclicals.”

And it’s just getting started, according to Michael Hartnett – Gary Baker’s partner at BOA: “It’s important to note that asset-allocators are still underweight equities, indicating they have yet to fully embrace the idea of a new bull market.”

One place they are embracing the bull market idea, however, is China, where investor bullishness is at a six-year high: “Investors looking to play the global recovery are using China and other emerging markets, rather than Europe or Japan, to do so,” Harnett said.

Opening the Financing Floodgates Into Municipal Bonds

Perhaps the most interesting place money appears to be flooding into is one area that sorely needs it: the municipal bond market.

In the midst of the financial crisis in the fourth quarter of last year, money was drained from the muni -bond market – and the 1,728 mutual fund share classes that invest in them. Investors pulled out $9.42 billion and market losses slashed another $$42.3 billion from the sector.

That was a tough time for many state and local governments, who rely heavily on municipal bonds to finance many large capital-intensive projects like schools, water and sewer plants, and hospitals.

Jed McCarthy, managing member of 1861 Capital Management, said, “People forgot ‘munis’ were safe credits.”

Well their memories have apparently returned: Investors are shoveling money back into municipal bonds at record rates – to the tune of $1.73 billion per week – according to AMG Data.

As a result, the muni market is appreciating once again, regaining $23.4 billion so far in 2009. Great news for investors and governments alike.

Newfound Interest In Municipal Bonds Has Staying Power

This newfound interest in municipal bonds will likely have staying power. The reason? Investors – many of whom were burned big time in the stock market last year – are looking to reinvest, but want a safer alternative than stocks.

They’re not ready for a full-on charge into equities just yet…

They are finding it in municipal bonds. Right now, 30-year munis (according to the Municipal Market Date-Line yield curve) offer a tax-exempt yield of 5.19%. This translates into an equivalent taxable yield of 8.5% (assuming Obama’s proposed top tax bracket of 39%).

As far as municipal bond funds go, there are literally hundreds of them. You can buy funds that contain bonds from nearly every state in the union, and most brokerages offer general, closed-end municipal bond funds as well.

iShares S&P National Municipal Bond Fund ETF (NYSE: MUB) and the SPDR Barclays Capital Municipal Bond ETF (NYSE: TFI) are two good ways to cover the entire space.

Check out www.municipalbonds.com for everything you need to know to get started investing in municipal bonds. But don’t wait for a market correction. We’re already in it.

Good investing,

David Fessler

Source: Municipal Bonds: Two Muni-Bond Fund Investment Opportunities

This from the LA Times:

The warning comes as California is close to running out of cash to fund day-to-day government operations and is unable to access routine short-term loans that it typically relies on to remain solvent.

The state of California is the biggest of several governments nationwide that are being locked out of the bond market by the global credit crunch. If the state is unable to access the cash, administration officials say, payments to schools and other government entities could quickly be suspended and state employees could be laid off.

Plans by several state and local governments to borrow in recent days have been upended by the credit freeze. New Mexico was forced to put off a $500-million bond sale, Massachusetts had to pull the plug halfway into a $400-million offering, and Maine is considering canceling road projects that were to be funded with bonds.

California finance experts say they know of no time in recent history when the state has sought an emergency loan of this magnitude from the federal government. The only other such rescue was in 1975, they said, when the federal government lent New York City money to avoid bankruptcy.

Read on here.

So far this year, $736 million in municipal bonds have defaulted. That doesn’t necessarily mean they didn’t pay investors; they may have just drawn down reserves. That’s what happens just before they stop making payments to bondholders.

During all of 2007, only $226 million in municipal bonds defaulted, according to the May edition of the “Distressed Debt Securities” newsletter, published in Miami Lakes, Florida.

“This is peanuts, at least so far,” says contrarian blogger Mish Shedlock. “However, Ambac (ABK) and MBIA (MBI), both of which are the equivalent of the walking dead, are staring at more nails in their coffins should municipal bond debt head south in a big way.”

“For the most part, however, the subprime crisis is past its inflection point,” says Eric Roseman in the Offshore A-Letter. “What matters now is how and when other credit indicators normalize.”

But Eric is highly dubious that credit markets have bottomed.

Sub-prime is now largely history. But other segments of the credit spectrum that have a far more profound impact on the American consumer are just beginning to unravel.

The consumer is now threatened by a liquidity crisis. Housing values continue to heavily contract and revolving credit installment debt is becoming harder to secure.

The culprit is less the write-downs themselves and more the virtual “shutdown” in the securitization market. At its height, the securitization market provided 66% of household borrowings in the first quarter of 2007. Without this market, consumer credit losses may be far worse than currently estimated.

Auto loans, personal loans, mortgage loans, and other segments of installment debt are still contracting. Auto loans are especially vulnerable with defaults recently hitting a 10-year high of 3.4% in March. And more Americans are dropping their house keys to their local lenders as housing values continue to plunge below the cost of their mortgages.

It’s not a new investment vehicle… It’s an old asset, where the opportunity has never been this good. I crunched the numbers, and I discovered we now have the best opportunity to buy in the 50-year history of this asset.

Right now, my savings account pays me less than 3% interest. At that rate, $10,000 would earn you less than $300 in interest in the course of a year. Then, of course, you also have to factor in income taxes on that $300…

So after taxes, you’ll pocket less than $200 on a $10,000 investment over a full year. It’s abysmal. So what can you safely do? You could tie your money up for a longer period of time… But 10-year Treasury bonds are only paying about 3.7%. And again, after taxes, you’re down to, well, not much. So what can you do?

You should consider buying tax-free municipal bonds.

———- Advertisement ———-
This One-Page Federal Letter has Predicted 58 of the Most Shocking Stock Swings THIS DECADE…

At first glance, it looks like any other piece of Government mail…

But this seldom-publicized and seldom-understood Federal Letter holds the secret to the easiest returns you’ll ever see in the US stock market.

Dr. George Huang – a PhD trader and former VC – has spent the past 12 months studying this letter, and discovered the secret to making money from it.

The next letter arrives on April 30th.

For more information, click here.
—————————————–

Right now, super safe, tax-free municipal bonds pay more interest than taxable treasury bonds. This is crazy.

Under “normal” circumstances, a tax-free investment should pay much less interest than a taxable one. For example, if you can earn taxable interest of 6%, then after income tax, you’d pocket about 4%. So if you could earn tax-free interest elsewhere, your “break even” interest rate would be about 4%. Said another way, interest of 6% taxable and 4% tax-free (at a 33% tax rate for this example) should be thought of as identical.

Interestingly, this is not the case at all today.

Thanks to the credit crunch, hedge funds sold their positions in municipal bonds about two months ago. Legendary fund manager Bill Gross started buying munis in March – by the billions. “When you can get a non-taxable security at the same rate as a basically taxable security, then you’ve got a bargain,” Gross said.

Another legendary value investor – Wilbur Ross – also bought a billion dollars worth.

Despite this buying, the anomaly is still here. Tax-free municipal bonds still pay more interest than taxable Treasuries. At the bottom of the market last month, the spread was the widest in history. Take a look:

As I’ve told readers before, this anomaly always sorts itself out in one of two ways: 1) Either regular government bond prices must crash while municipal bonds stay flat. Or 2) Municipal bond prices must soar. Either way, you’ll do extremely well by holding a portfolio of municipal bonds.

Municipal bonds are safe… The cumulative default rate on municipal bonds from 1970 to 2000 (the only numbers I have) was 0.04%. And that number is for all municipal bonds, not just the highest-rated, AAA ones.

Municipal bond prices fell recently. But the uptrend is back.

You can invest extremely safely in boring municipal bond funds from companies like Vanguard. Or you can significantly increase your tax-free yields by going with a closed-end municipal bond fund. I currently recommend two municipal bond funds to True Wealth subscribers. You can sort through a list of them at www.etfconnect.com.

As I’ve said to True Wealth readers… between the tax-free interest and the capital gains I expect as the anomaly sorts itself out, you should be able to pick up double-digit total returns here over 12 months. Safe, double-digit annual returns on your cash, tax-free, is hard to beat.

Good investing,

Steve

P.S. You can learn more about my top two fund ideas with a subscription to True Wealth. To learn more about joining up, click here. (The tax-free interest you earn this year will easily pay for the subscription!)