Investors have recently sold off municipal bonds and there could be more selling on the way.

HYD

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On yesterday’s U.S. television news magazine “60 Minutes”, reporter Steve Kroft lead a segment that focused on the growing financial woes of state and local governments.  According to Kroft, state and local pension funds are underfunded by over $1 trillion and things are likely to get worse before they get better.

The state of Illinois spends twice what it takes in from tax revenue and is six months behind in paying its bills.  Other states with a large public workforce including California, New York and New Jersey are also in trouble.  The federal government has helped state and local governments cover the shortfall, but that $150 billion of aid is scheduled to end in the spring of 2011.

The traditionally staid U.S. municipal bond market is worth over $3 trillion.  However, 2011 could bring dozens of defaults according to analyst Meredith Whitney.  In her interveiw with Kroft, Whitney suggests that the market will see as many as 50 to 100 defaults next year.

Municipal bonds are popular with exchange traded fund investors with over $8 billion in tax-exempt ETFs.  The largest funds include the $2 billion S&P National Municipal Bond Fund (MUB) which tracks the investment grade portion of the market. The $1.3 billion Barclays Capital Short Term Municipal Bond ETF (SHM) and $900 million SPDR Barclays Capital Municipal Bond ETF (TFI) track a similar, less risky segment of the market.

Whitney believes that, despite massive deficits, state governments will find a way to stay away from default.  She is more concerned with local authorities which have less of a tax base. One recent example – the city of Harrisburg had to be rescued by the state of Pennsylvania to avoid defaulting on a bond tied to an incineration project.

In the ETF market, trouble is most likely to appear in the portfolio of the High-Yield Municipal Index ETF (HYD).  The exchange traded fund is the nation’s first ETF to focus on high-yield munis, and tracks an index that has a 25% weighting in investment-grade triple-B bonds and 75% weighting in non-investment grade bonds.  Top 10 holdings include bonds issued by local authorities in New Jersey, Pennsylvania, Illinois and California.  Industrial development bonds are the second largest sector in the portfolio behind health & hospitals.

For more, see the complete list of tax-exempt fixed income ETFs in the ETF Directory.