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Mapping the Risky New World of Municipal Bonds


The economic slowdown will make it hard for some muni bond issuers to pay their debts. As yields rise, investors must rethink their approach

Many municipal bond investors are enjoying unusually high yields. While returns on munis have historically been about two-thirds those of U.S. government securities, they are paying higher rates than Treasuries in the current credit crisis—roughly 4.2% on a top-rated, 10-year bond.

(A 10-year Treasury yields 3.61%.) In the taxable world, that 4.2% is equivalent to a 6.4% yield for someone in the 33% tax bracket. And these bonds have rarely, if ever, defaulted.

What's going on? The muni market is roiled by jitters over how an economic slowdown—and the resulting lower tax revenues—will affect the ability of municipalities to pay their debts. "Either the market is mispricing the risk because of the turmoil in the credit markets or it is forecasting that we are going into a depression," says David Kotok, chairman and chief investment officer of Cumberland Advisors, a Vineland (N.J.) money management firm.

It's a bit of both. Municipal bonds have been in the news recently, and for all the wrong reasons. In Alabama, Jefferson County is poised to declare bankruptcy—the largest muni bankruptcy ever—if terms on its bonds can't be renegotiated. Other municipalities, including East Bay Municipal Utility District in Oakland, Calif., use complex financial instruments called interest rate swaps, which leave them open to risk if the financial institution on the other side of the deal should fail. With the economy sliding into recession, cities and states will have a tougher time meeting budgets as tax revenues fall. "There's more credit risk than in the past," says Greg Friedman, chief investment officer of adviser Greycourt & Co. in Portland, Ore.

But the fall in bond prices has as much to do with technical issues in the market as with fear of default. The problem started early in 2008, when the bond insurers' sideline of insuring mortgage-backed securities blew up. This lowered their AAA ratings and those of the muni bonds they insured. At the same time, hedge funds and other institutions looking to raise capital by selling their most valuable assets dumped munis, which caused prices to plunge. Then the auction-rate securities market, which municipalities use to borrow short-term funds for their long-term needs, dried up. That left the muni bond market jammed with cities and states looking to issue longer-term bonds. But no one was buying. As the credit crisis deepened, investors rushed into Treasuries. Issuers sold only $878 million worth of bonds from Sept. 29 to Oct. 3, down from $1.4 billion two weeks earlier—and from an average of $6 billion a week earlier in the year, according to Bloomberg Financial Markets. "People want diamonds right now," says Richard Ciccarone, chief research officer of McDonnell Investment Management. "And munis aren't perfect diamonds."

In such an unsettled environment, muni bond investors need a new road map. Individual investors, whether creating their own portfolio of bonds or choosing among muni bond funds, used to be able to look at credit ratings and be reasonably certain they were getting safe investments: Only 0.15% of investment grade bonds defaulted from 1986 to 2008, according to Standard & Poor's (MHP). But with one investment-grade municipality—Vallejo, Calif.—already bankrupt in 2008 and Jefferson County perhaps preparing to follow, ratings are a place to start the process, not finish it. Gauging true creditworthiness now requires more digging.

PITTSBURGH HAS PLUSES

Investors need to take greater care in checking out the source of their bond's interest income, or in making sure that their fund manager or financial adviser is doing so. The more sources of revenue that support a bond, the less likely it is to default. A city with multiple revenue streams—income tax, sales tax, and property tax, for instance—will be more likely to make good than a smaller town or a school district that can tax only property, especially in a world of falling real estate. While AAA-rated bonds are the safest, some experts, including research firm Municipal Market Advisor's managing director, Matt Fabian, see value in BBB-rated general obligations, the lowest of the investment grades. Fabian offers the example of Pittsburgh, a BBB-rated bond that offers a yield of more than 5%, a point and a half above the average AAA-rated bond—and equal to more than an 8% taxable return if one assumes a tax rate of 35%. Because of its diverse revenue streams, Pittsburgh may be insulated from some of the general economic fury, and so may be a better bet than a smaller municipality.

Revenue bonds, backed by proceeds generated from a distinct project, have always been slightly riskier because of that single income stream. Now, however, investors should seek out bonds funding truly essential services, such as water treatment, sewers, and utilities.

For the truly risk-averse investor looking for a little more yield than a Treasury offers, there are pre-refunded munis. What are pre-res? When a municipality wants to pay off a bond, it can buy Treasuries, place them in an escrow account, and use the proceeds to pay the muni bond's premiums, making them almost as safe as a U.S. bond, but tax-free.

Before the credit crisis, pre-res drew little attention. But with safety at a premium, they've held up better than other munis. For example, a Treasury expiring in five years has a 2.65% rate. An Orlando pre-re muni maturing in four years carried an interest rate of about 3.2% as of early October, giving investors half a percentage point more for what is essentially the same security. With these bonds, "it doesn't matter if a municipality falls into the ocean," says Daniel Genter, president of RNC Genter Capital Management. "You'll get your money back."

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Muni Ratings Redux

Prior to 1929, almost all muni general obligation bonds were rated Aaa or Aa. By 1935 as many as 3,252 munis had defaulted, says an April paper by McDonnell Investment Management. The Great Depression ushered in tougher rating standards. The paper cautions "those who advocate sweeping upgrades to municipal government ratings (presumably to Aaa and Aa levels)" to beware a "complacency of positive expectations." On Oct. 7—after the story on page 78 went to press—ratings firms postponed recalibrating muni ratings because of market conditions.

To read the paper, go to http://bx.businessweek.com/municipal-bonds--


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