Headline risk dogs muni market heading into 2011

CHICAGO (Reuters) - States, cities and other issuers in the U.S. municipal bond market remain under financial stress, but the steady drum beat of warnings of an imminent crisis may be overstated, say analysts and others.

“I have a feeling 2011 will be a year when there’s going to be a good amount of headline risk and will be very politically charged and it will be difficult for retail investors to understand what is going on,” Tom Kozlik, a municipal credit analyst at Janney Capital Markets, said on Thursday.

Individual investors no longer have the security blanket of triple-A insurance wrapping their muni holdings as bond insurer ratings have dropped along with the amount of insured new issues, which has fallen to around 7 percent from about 50 percent.

Meanwhile, these investors are being bombarded by media reports, including a recent “60 Minutes” episode on the CBS television network on which Wall Street bank analyst Meredith Whitney predicted 50 to 100 “sizable defaults” by local governments amounting to hundreds of billions of dollars.

In a market comment this week, Kozlik said there are no indications that defaults will be “excessively higher” next year and while the market’s landscape will be volatile, there will not be a crisis.

For the first three quarters of 2010, there were 63 muni defaults totaling $2.12 billion, compared to 163 defaults totaling $5.45 billion during the same period in 2009, Richard Lehmann, publisher of Distressed Debt Securities Newsletter, said last month. Meanwhile, corporate defaults during the same time period were five times higher at $11 billion.

Despite doom and gloom headlines, the muni market has been relatively calm this week, with prices unchanged to slightly higher. On Thursday, Municipal Market Data’s triple-A scale was unchanged with 10-year yields at 3.14 percent and 30-year yields at 4.66 percent.

“The overwhelming majority of local and state governments are balancing their budgets and meeting their debt obligations,” said Christopher Hoene, research and innovation director at the National League of Cities, in a statement on Wednesday that took issue with Whitney’s predictions.

He pointed to low debt levels for states and local governments, long-term and predictable borrowing and balanced-budget requirements as safeguards in the market.

Still, revenue has not recovered to pre-economic recession levels and states and cities face tough choices in their upcoming budgets, particularly as the flow of billions of federal stimulus dollars dries up.

As a result, there will be a “significant consolidation of government functions during this recovery period,” said a market comment on Wednesday from RBC Capital Markets municipals strategist Chris Mauro.

“In our view, this exercise in right-sizing will, over the long term, position the states for sustainable improvement in credit quality once a strong recovery in employment and earnings really takes root,” Mauro said.

This process, however, could result in funding cuts to local governments, which in turn could see credit problems, he added.

Retirement benefits due government workers remain a looming and huge problem and many states will start 2011 with new laws that require bigger employee contributions for pensions and that increase the retirement age, according to the National Conference of State Legislatures. Some newly elected governors who will take office early next year have also put pensions on their list for cost cutting.

Editing by Theodore d’Afflisio