Author and former analyst Fred Sheehan writes that the municipal bond market is ripe for collapse. He states that investors are naive if they think that munis are a safe place to stash cash. His main thesis is that:

• Losses on pension investments will require much higher levels of future contribution, further taxing municipalities.
• Spending in states, cities, and towns has exploded and shows little sign of abating.
• Municipalities can no longer rely on accounting gimmicks to balance the books.
• Disclosure to retain investors is poor and thus many are saddled with bad bonds.

So is this a problem? I did a little bit of research and discovered that municipal bond investors should be concerned. First, let's state that municipal bonds are generally much safer than corporate bonds. Municipal bankruptcy filings are very rare in comparison to their corporate cousins. Of more than 55,000 municipal entities, fewer than 600 have filed for bankruptcy protection since 1937.

In comparison, for the 12 month period ending June 30, 2007 alone, the Administrative Office for the U.S. Courts reported Chapter 7 filings of 450,332, Chapter 11 filings of 5,586 and total business filings of 23,889.

But rising salaries and pension obligations are threatening the finances of municipalities at the same time that revenue is dropping. Think the city equivalent of General Motors. Indeed, according to an interview done with James Spiotto, Partner, Chapman and Cutler LLP:

"Consider this staggering comparison: State and local public employees comprise approximately 12 percent of the U.S. workforce and have an estimated $800 billion or more of unfunded pension liabilities (not counting other post-employment benefits). By comparison, employees in the private or corporate sector make up about 78 percent of the U.S. workforce with an estimated $450 billion of unfunded liabilities."

That's a staggering pension liability borne by every non-public employee who pays taxes. Other figures show that public employees now make 120% of private-sector employees when wages and benefits are included. Working for the government has never been more lucrative.

The city where I live recently had an override vote. It was narrowly rejected. But  at the same time, the teachers, firefighters, policeman, etc. are still expecting to receive their 3-4% salary adjustments. That's fine, but the voters should look at what happened to Vallejo, CA. It needed to file for Chapter 9 because pension and salary obligations overwhelmed its budgets.

Municipal bond investors should keep a sharp eye on those municipalities that are able to manage their budgets, and those that are spending money like its 2006 again. Because although municipal bond defaults are rare, they can happen.