The ticking clock is a great device for creating dramatic tension on screen. You might get up to go get a snack when the lead actors are emoting, but nobody leaves when there is three seconds left on the device that is going to explode. Maybe that is why there is so much fuss in the financial media about the impending detonation of the municipal bond market.

Safe and Sleepy... Usually
In normal days, municipal bonds are arguably one of the sleepiest and most boring segments of the financial marketplace. Munis are bonds issued by communities or enterprises to pay for things like roads, hospitals and schools. So dull are they that there is typically no active quotation system for them - they trade seldom enough that you have to call your broker, who will then call around to get bid/ask quotes on the bond. (For a quick refresher, check out The Basics Of Municipal Bonds.)

Now, though, that may be changing.

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Trouble Afoot?
With the stock market more or less on its feet and the government, corporate and mortgage bond markets functional once more, attention is turning to the muni market as the next potential disaster zone. Sources no less significant than The Economist and Time have both addressed pending trouble in munis in the last couple of weeks.

The problem here is pretty straightforward. State budgets across the country are in shambles as tax receipts have fallen with the recession, but spending demands have not shrunk on their own. A survey from the Center on Budget and Policy Priorities shows 46 states with projected shortfalls for fiscal 2010 and a total shortfall of $200 billion. The CBPP further estimates that the shortfalls could reach $180 billion in 2011 and $120 billion in 2012. For a little perspective, the last recession (2002-2005) saw a total shortfall of about $240 billion.

Making matters worse, over 80% of municipal bonds are rated by Moody's (NYSE:MCO) and McGraw-Hill's (NYSE:MHP) Standard & Poor's. You remember those guys, right? The ones who handled the mortgage bond market so well. Assuming that the rating standards were just as strong and that the companies have been equally diligent in monitoring ongoing conditions, we may want to assume that Daffy Duck is steering the Titanic on this one. (For related reading, check out Fatal Seduction Of The Municipal Bond Insurers.)

Potential Fallout
Individual investors, mutual funds, pension funds and insurance companies are all major owners of municipal bonds, as well as banks. So if communities find themselves unable to pay, the pain is going to be widespread. Worse still, these bonds occupy a segment of portfolio allocation that just does not accept much risk and that could make matters much worse.

Beyond the holders, though, there will be even more pain to spare. Major muni underwriters like Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Barclays (NYSE:BCS) can hardly handle any more scandal. Moreover, underwriting and trading municipal bonds is a relatively lucrative business, and the prospect of having yet another profitable niche for banks freeze up and shut down cannot be good news for the economy.

What can You Do?
On one hand, investors should take some comfort in the fact that muni defaults have been rather rare over the course of history, and usually there are no total losses - payments are often rescheduled and stretched out, but not canceled. Then again, conditions have never been quite like this before, so maybe the old rules do not apply.

I am also actually encouraged by the skepticism. When the mortgage bond market collapsed, it was preceded by a "what, me worry?" sort of attitude that completely discounted the possibility that U.S. housing prices could drop by double-digit amounts, let alone for multiple years. Similarly, though there have been widespread fears about commercial real estate, it seems as though those fears have led to prices readjusting in a more orderly fashion and avoiding a crash. So with so many people worried about munis, maybe there will be a gradual deflation instead of a traumatic "pop".

The Bottom Line
I would not rush to sell any munis just yet, but if I were considering new purchases, I would make sure I understood the revenue streams that supported those bonds. Also, it is very much a local phenomenon - the budget issues in Massachusetts, for instance, look quite a bit more manageable than those in Minnesota or New Jersey. I would also give serious thought to a diversified approach, like a mutual fund or closed-end fund that would spread some of the risk around, but maybe it is just best to wait for things to sort themselves out. After all, there are plenty of companies out there paying generous dividends these days.

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