'Storm clouds are gathering'

Last week I received an email from a friend and former currency trader with "Storm clouds are gathering" written in the subject line. He was referring to the municipal bond market. Just as trouble in the mortgage-backed securities market led to the 2008 financial debacle, munis may be signaling the next systemic crackup. Investors withdrew $8 billion from municipal bond funds last month, perhaps the worst four-week money flow period in the history of that business.

Municipal bonds-bonds issued by state and local governments to finance projects like roads, school buildings, and water and sewer systems-have traditionally been a safe place to park money and receive a healthy tax-sheltered yield. With bank interest rates at historic lows, many conservative investors have turned to alternative markets like muni bonds and muni bond funds to boost their income. Take look at look at the charts that my friend sent me to see the nasty hit bond funds took recently. Can you say "crushed?" Ouch!

What's going on?

As usual, the federal government's fingerprints are all over this volatility. Seeking to terminate the municipal bond subsidy program, called "Build America Bonds," as part of the tax compromise legislation, Congress and President Obama spooked the muni market last month. With the feds likely to end their intervention in the market (hooray), municipalities will have to carry their own weight. They'll be issuing billions of dollars more in municipal bonds, which is likely to lower the value of existing bonds. Anticipating this development, investors have been dumping muni bonds and muni bond funds and whacking the markets in the process (see my friend's charts or this chart).

Adding to investors' concerns is the risk of default by big municipal bond issuers like California, New York, and Illinois. Think "Greece," which threw the European Union into turmoil last spring when it needed a bailout. California is big in trouble and its economy is five times larger than that of Greece. Bond buyers are wondering if a new and more conservative Congress will be willing to bail out the big blue states if they fail to make massive cuts in their budgets. Many investors aren't willing to take the risk and they're cutting their losses early.

Remember the mortgage-backed securities crisis of 2008? If you have a retirement account you do. Be careful, watch the muni market because it could trigger another collapse across a wide spectrum of the financial world.