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Cities Could Be in Big Trouble

American cities are about to run into some serious financial trouble. Athough President Obama and John Boehner still have strike a deal to avert the fiscal cliff, investors are already betting that new taxes on municipal bonds are on the way. The Wall Street Journal has more:

Investors pulled $2.3 billion out of muni-bond funds in the week ended Wednesday, according to data collected by Lipper from funds that reported weekly. This is the biggest outflow since January 2011. . .

So far in December, total returns for muni bonds have fallen 1.5%, on track for the largest monthly drop in two years, according to Barclays . Year-to-date, muni bonds are up 6.5% through Wednesday, when the market stabilized. Total returns reflect coupon payments as well as changes to bond prices.

By comparison, Treasurys are down 0.7% this month. Muni bonds usually perform better amid weakness in fixed-income markets, says Matt Fabian, managing director at research advisory firm Municipal Market Advisors. He says munis’ uncertain tax status is a major factor in the recent performance.

As we noted last week, this amounts to a body blow to the core of municipal funding. If investors continue to pull out of the muni bond market, city after city will see its borrowing costs rise. This is a tricky situation for any mayor, and it could be catastrophic for cities where major budget shortfalls require extensive borrowing to keep basic services running.

We’ve been predicting a day of reckoning for cities like Detroit and Providence for some time now. If borrowing costs continue to rise, this day may come sooner than we thought—and to more cities than we thought.

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