Municipal bonds are "Main Street investments," with an estimated 73% of the $3.7 trillion in outstanding principal owned by households or mutual funds1. On the other hand, municipal bonds are traded in an over-the-counter (OTC) market where dealers create liquidity. Main Street depends on Wall Street, and vice versa, with both sides benefitting. Enter the Volcker Rule, named for former Fed Chairman Paul Volcker, and proposed in response to the devastating 2008 economic crisis. The Rule seeks, among other things, to limit proprietary portfolio trading by banks, especially activities of the speculative or rogue variety that could harm investors. Certain securities are exempt – U.S. Treasuries/Agencies and General Obligation municipals. However, thousands of revenue muni bonds that depend on dealer liquidity are not exempt, and are vulnerable to the Rule's unintended consequences.Muni proponents are objecting that the Rule goes too far and could create a loss of confidence in thinly traded issues. In a recent letter, Citigroup Global Markets stated: "If this (Rule) were to occur in an environment where dealers' abilities to provide liquidity were severely compromised by the Volcker Proposal, the effect of individuals liquidating into a distressed, illiquid market would be devastating for existing bondholders and issuers2."In response to the avalanche of dissent, Volcker Rule implementation has been pushed back from its summer deadline. For now, I believe that the symbiotic relationship between Main Street investors and muni dealers is working well, and markets are trading efficiently. I expect that Congress and financial regulators will listen to the rising chorus of voices and leave well enough alone.
_________________________1Reuters, 12/22/11 using data from the Federal Reserve Flow of Funds, December 2011. 2Letter from Citigroup Global Markets Inc. to federal regulators, 1/27/12.
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Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Bonds and bond funds will decrease in value as interest rates rise. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.
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