Municipal bonds investors might be headed towards a storm, which may cause significant damage to their portfolios. Cities within the U.S. economy are in distress—they are struggling to keep their spending in order to not increase their budget deficit.

Detroit, one of the biggest cities in the U.S. economy, was handed an emergency manager by the state to take care of the city’s budget deficit. The city is running a deficit of $327 million and has $14.0 billion in long-term obligations—mainly municipal bonds backed by the city’s water and sewer systems. (Source: “Snyder Says Detroit Needs Emergency Manager to End Fiscal Crisis,” Bloomberg, March 1, 2013, last accessed March 21, 2013.)

Michigan’s Governor, Rick Snyder, explained the city’s situation, saying, “it’s a sad day, a day I wish never happened, but it’s a day of promise.” (Source: Ibid.)

If the state didn’t intervene, then Detroit would have been the largest municipal bankruptcy in the U.S. economy—leaving municipal bonds investors in misery. In November 2011, Jefferson County, Alabama was the largest municipal bankruptcy in the U.S., involving more than $3.1 billion in municipal bonds.

Municipal bonds investors have enjoyed tax advantages in the U.S. economy, but if there is a downturn in these types of bonds, then the benefits will quickly disappear.

What’s ahead for municipal bonds investors looks even more troublesome. Williston, North Dakota’s municipal bonds were downgraded by Standard and Poor’s from “A-” to “BBB+.” (Source: KFYR-TV, February 28, 2013.) The municipal bonds credit rating went from being in the upper investment grade to almost the non-investment grade.

Moody’s Investor Services has downgraded 11 municipalities in the U.S. from stable to negative—and all these cities had a credit rating of “AAA” prior to the downgrade. (Source: Barron’s, February 6, 2013.)

On top of this, the housing market in the U.S. economy is still facing severe stress. From their peaks in 2007, home prices are still down about 30%, with very little hope in getting back to those pre-recession price levels. Remember: for municipalities, property taxes are the biggest source of revenue. Until the U.S. housing market becomes strong, the ability of cities to earn revenue will remain bleak.

And if interest rates in the U.S. economy increase, which they eventually will to hold down inflation, municipal bonds investors will face further threat. A simple rule of economics: bond prices fall when interest rates go up.

As this all unfolds, I believe municipal bond holders will become a victim. In fact, these investors are very vulnerable right now. I am keeping a close eye on the municipal bond market and struggling American cities. This municipal bond market problem could take the U.S. economy into much deeper troubles than we are already experiencing.

What He Said:

“A Stock Market’s Obituary: It is with great sadness that we announce the passing of the Dow Jones Industrial Average. After a strong and courageous battle, the Dow Jones fell victim to a credit crisis and finally succumbed on Friday, October 3, 2008, when it fell decisively below the mid-point between its 2002 low and its 2007 high.” Michael Lombardi in Profit Confidential, October 6, 2008. From October 6, 2008 to November 27, 2008, the Dow Jones Industrial Average experienced one of its biggest two-month losses in history.