Bond expert: It's not your father's muni market

By Mark Jewell AP Personal Finance Writer BOSTON (AP) -- It wasn't long ago that municipal bond funds provided a reliable refuge from stock market volatility. Investors could expect steady returns of 4 to 5 percent a year. The appeal of muni bonds is that their interest payments are exempt from federal taxes, and most state and local taxes. Although this safe-haven approach won't make anyone rich, it can provide a decent return. That's especially true for investors in high tax brackets who take a bigger hit on their investment income from Uncle Sam. Another selling point for investors is that municipal bonds are used to help communities grow. Munis are essentially IOUs issued by state and local governments to fund projects such as schools, hospitals, roads and bridges. Yet investors seem to have forgotten munis' best features lately. They've stampeded out of muni bond funds, withdrawing a net $45 billion in the past six months, according to Morningstar. That's about 9 percent of the assets these mutual funds held last fall. Investment returns have also been uncharacteristically volatile. Bond yields rose in the fourth quarter of last year to pay investors for the higher risks they perceived in the marketplace. That increase depressed the prices of previously issued bonds paying lower yields, leaving bond fund investors with losses. In the end, muni bonds fund fell an average 4.6 percent, their worst quarter since 1994. There's been a rebound this year, with muni bond funds up an average 3.4 percent. Even so, it's clear the muni market is no longer a quiet place. Investors are worried about the precarious health of state and local government finances following the recession. But the turmoil is also the result of more fundamental changes in the muni market since the 2008 financial crisis. Trying to make sense of it all is Natalie Cohen, whose muni market résumé includes high-level positions at a bond insurer, a credit ratings agency, and New York City's budget office. She now directs municipal research at Wells Fargo Securities, advising institutional investors, including mutual funds. In a recent interview, Cohen discussed the changes, and how muni investors can navigate them. Here are excerpts, edited for clarity: Q: Besides the fears about the financial troubles of their local governments, what factors have been driving investors away from munis? A: First, it's important to remember that the recent withdrawals followed a period when money flowed in during the financial crisis, during a flight to safety. Munis' tax protection looked attractive when the government was busy with stimulus programs and bailouts. The fear was government was going to keep getting bigger, and it would lead to a tax-and-spend environment where you'd want to shield your money from higher taxes. Then, in December we saw the end of Build America Bonds (a stimulus program that provided federal subsidies to encourage construction of new roads and other local projects). That program brought new buyers into the muni market who traditionally weren't drawn to it, because they're already tax-exempt and didn't benefit from munis' tax benefits. Pension funds are an example. That program kept muni yields artificially low, and prices high. Now that the program has expired, it's pressured the muni market, and bonds dropped in value late last year. Muni fund investors looked at quarterly statements, and said, 'My God, I've lost so much value on my investment. Why bother with this? I can go into the stock market and do a lot better. Q: Investors began pulling out of munis just after the November mid-term election. Was there a connection? A: Republicans made gains in Congress and in governors' offices, and vowed to reduce spending. That put more attention on the health of state and municipal finances. Then, Congress agreed in December to extend the Bush tax cuts (the agreement kept historically low rates in place on dividend income and capital gains). That made munis' tax protection less appealing, and investors went elsewhere. Then, there was the "60 Minutes" episode, which many individual investors heard about. The story went viral across the press. (The episode featured an influential analyst, Meredith Whitney, who forecast the possibility of 50 to 100 sizable defaults in 2011 worth hundreds of billions of dollars. The default rate on municipal bonds is now at 0.53 percent, which is slightly lower than the rate at the end of last year, according to Standard & Poor's.) Q: Do you agree with Whitney's warning about a spike in defaults? A: She overstated the risks. But I think she was correct that there has been complacency. We've had almost an entire generation of muni investors who were used to operating in a market where bond insurance provided a backstop against credit risk. There was this overriding view that munis don't default, and you're safe if they have the cover of a Triple-A rating. But insurance coverage of newly issued munis peaked in 2005, and has fallen sharply since then. So the complacency has gone, and munis have become a credit investment, instead of a generic, homogenized investment. Q: What's going on now? A: We're starting to see small amounts of money moving back into muni bond funds. There was a rally that started in mid-April. People looked at reports showing state revenues were improving, and said, "No, we're not going to see a spike in defaults." Hopefully, price volatility will ease in the second half of the year. But expect to hear lots of noise for a while about state and local government finances. This is still a tough economy, and most states are finishing up work on their budgets for the fiscal year that begins in July. Q: Any advice for investors who want to research muni risks? A: There's a lot more information than there used to be. There's a free system for researching muni financial disclosures, run by the Municipal Securities Rulemaking Board, and called Emma -- Electronic Municipal Market Access. It's available at www.msrb.org . It's important to remember that muni risks are modest. Most of these bonds are for basic, essential services -- water and sewer systems, electricity, public transit, and so on -- not to finance government operating budgets. You have to be a little more careful with projects in states that have been hit especially hard in the recession, like Florida, California, Nevada and Arizona. These days, muni investors just have to dig a little more, and know what they're investing in. ---------------- Questions? E-mail investorinsight@ap.org Published: Wed, Jun 1, 2011