If major sovereign borrowers like Germany and the Netherlands are having difficulties raising weekly bond auctions since October, imagine what lies ahead for many distressed U.S. municipalities in 2009. The picture isn’t pretty, unless the Federal government under Obama bails out the weakest credits, including California, now in the midst of yet another full-blown budget crisis.

Municipal bonds have already suffered huge historical declines this year with most of those losses occurring earlier in the year. Muni bonds are offered on a tax-free basis at the Federal level and currently provide hefty tax equivalent yields to investors.

Indeed, even now the spread between municipal bonds and the ten-year Treasury bond remains wide at 2.27%, or 227 basis points. That’s near the high recorded about ten months ago (5.02%) when the sector began to unravel on funding concerns and fears of default. In September, the sector crashed again only much harder following Lehman’s bankruptcy. The Merrill Lynch Muni Master Index currently yields 4.43%.

Earlier this fall, investment grade municipalities, New York and New Jersey, attempted to raise money for the Port Authority, part of the bi-state transportation chain. Despite offering attractive terms on a short-term note, the sponsors scrapped the auction because of tepid interest. Not a bullish sign in times of acute credit stress.

If you own municipal bonds or mutual funds invested in municipal bond securities my advice is to make sure they’re not more than 5% of your portfolio.

I really don’t care about the attractive tax-equivalent yields now offered; fears of rising defaults make holding these securities risky amid a credit crunch. Many cities and towns are now entering a crisis funding environment and unless Obama offers fast relief, a wave of defaults is likely in 2009.

I’m off to Florida until Monday, January 5 and I won’t be blogging while on holiday.

On behalf of the fine team at The Sovereign Society, have a happy and healthy New Year and I certainly hope 2009 is a better year for investors. We can all use some holiday cheer.

See you on January 5.