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Muni Bond ETFs: Ticking Time Bomb?

NEW YORK ( TheStreet) -- The sovereign debt crisis in Europe shows how massive public debt can create significant problems for governments and roil global markets.

But as investors continue to watch Europe they should also pay attention to state and city governments here at home, because these local governments may be headed for a eurozone-style crisis.

The Great Recession caused tax revenue to fall significantly, creating budget shortfalls for state and local governments. With unemployment still hovering around 10%, state governments continue to see income tax revenue decline. Meanwhile, sales tax revenue has also suffered as consumers have cut back on discretionary spending and purchases of big-ticket items.

Local property tax revenue may suffer going forward as property reassessments done over the past 18 months start to kick in.

Second, massive amounts of state and local debt that was taken out to fund state-funded pensions and other long-term liabilities are starting to come due. Numerous state agencies have implemented furloughs and forced unpaid vacations in order to cut spending.

Thirdly, there aren't many insurers to back municipal bonds anymore. The credit crisis caused many bond insurers to shut their doors, increasing the risk of investing in municipal bonds. According to the Municipal Securities Rulemaking Board, currently less than 10% of newly issued municipal bond issues are insured. In 2008, more than 50% of all municipal bonds were insured.

Lastly, the trend of municipal bonds defaulting has already emerged. Since July of 2009, 207 municipal issuers have defaulted on bonds valued at a total of $6 billion. This included a major default in Las Vegas, backed by a Monorail project, and a Chapter 9 bankruptcy in Vallejo, Calif.

As for the future, things don't seem much more promising. The number of defaults is expected to continue to increase as local governments in places like Harrisburg, Penn. and Jefferson County, Ala. have openly mentioned bankruptcy. Meanwhile, the likelihood is high that a major municipality like Detroit or Los Angeles will be unable to meet its obligations.
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