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Monday, May 4, 2009

Could Municipal Bonds Really Default?

When Warren Buffett speaks, it’s usually worth paying attention. This time, the Oracle of Omaha is voicing concerns about the ability of some battered local and state governments to pay off their debts. The idea of cities and states facing insolvency is alarming for sure, and Buffett isn’t alone. Moody’s recently assigned a “negative outlook” to the creditworthiness of all the nation’s local governments. The agency has rarely made such a sweeping generalization but said the magnitude of this recession warranted the move. The comments are the latest to have shaken the once-staid world of municipal bond investing.

Traditionally, muni bonds offered lower yields — usually about 20% less — than Treasury bonds, since their income isn’t taxed. But the group was crushed last year, sending prices down and yields up. Now bargain hunters have started to emerge, attracted by yields that are as much as 70 basis points, or 0.7%, more than similar 10-year Treasurys, for example. As a result, the S&P Muni index has climbed 7% this year, compared with the nearly 6% decline in the broader stock market.

These low prices reflect investor concerns about possible downgrades, says Daniel Solender, director of municipal bond management at Lord Abbett. The Federal Reserve’s buying spree in other areas of the bond market is also depressing yields of Treasury bonds and making municipal bonds all that more attractive. And then there is the $100 billion fiscal stimulus headed toward the states that should help offset the shortfall in tax revenue, says TD Ameritrade Chief Investment Strategist Stephanie Giroux, who adds that historically there has only been a 1% default rate for muni bonds.

“There is some risk, but if you can earn three times buying municipal bonds diversified across the United States and backed by the taxing authority of the states, maybe it’s worth it,” said Gregg Fisher, chief investment officer for advisory firm Gerstein Fisher.

The key is to pick carefully. Here are some tips for bargain-hunters:

• For the most part, it’s worth sticking with so-called general obligation bonds that finance essentials like water and sewers which can be paid back with tax revenue the city or state collects. The recent stimulus spending for health care and education has some pros dabbling with high-quality hospital and university bonds funded by those institutions’ revenue. But it may be worth paying the experts to do the picking or at least sticking with shorter-term options since stimulus spending won’t last forever.

• While most individual investors buy bonds offered by their own state for the extra tax advantage, it pays to diversify nationally by buying bonds of states facing different economic prospects. In other words, don’t invest only in states dealing with, say, a battered real estate market. While Fisher says allowing a state like California to go bankrupt would be akin to throwing it in the ocean, it’s worth protecting against an unlikely default. “In a portfolio of 20 bonds, if one defaults, you only lose at most 5%,” he says.

• Stick with shorter-term durations in general, preferably less than five years. Fisher recommends laddering municipal bonds, buying durations of one to five years, perhaps more maturing sooner if you expect inflation down the line.

• Keep an eye on bond ratings — not just the actual rating but also the trend of the rating to gauge whether the city or state’s health is improving or deteriorating. Check a state or city’s web site to find the sources of income for the bond.

Disclosure I own some muni bond etfs, no individual muni bonds.

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