Trade idea: Advisers suggest lower risk muni bonds

BOSTON Fri Feb 11, 2011 1:10pm EST

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BOSTON (Reuters) - Financial advisers and fund managers are starting to challenge some of the most common and cherished investing axioms of the municipal bond market.

The near-disappearance of bond insurance, well-publicized financial troubles of some states and cities, as well as recent selling pressures, have increased both the risks and the complexity for individuals who want to invest in tax-exempt debt.

And that means the end of telling investors simply to buy a smattering of 20-year and 30-year bonds from issuers in their own state to hold until maturity.

The municipal market is now much like the corporate bond market, with prices driven more by the individual characteristics of each issuer, San Francisco financial Milo Benningfield said. Risk awareness is the new theme, he said.

"I don't think all this means individual purchasers should abandon munis," Benningfield said. "They just need to recalibrate their expectations and be more sensitive to the risks going forward."

For investors with a low tolerance for risk, such as someone setting aside money that might be needed in the next year or two, financial advisers suggest dramatically rethinking the use of municipal bonds and funds.

Conservative investors may have too much of their wealth tied up in municipal bonds, according to Elizabeth Fell, fixed income strategist at Barclays Wealth. The firm recommends conservative investors put only 12 percent of their assets in municipal debt and 43.5 percent in cash and short-term instruments.

Cutbacks are obviously already ongoing among muni fund investors, who have withdrawn almost $25 billion from tax-exempt mutual funds in the past three months. Much of the money has moved to money market, short-term and floating rate taxable debt funds.

One of the most common tendencies of muni investors -- to buy bonds issued only within their own state -- should also be rethought, advisers said. Residents of a state with an income tax, like California or Massachusetts, save the most on taxes by buying only in-state issues.

But given the greater risks in the market, sticking to one state does not provide adequate diversification. "We're viewing risk differently than we did the past few years about having a concentration in one location, which may also be where the investor has their home and business," Barclays' Fell said.

MODERATE OUTLOOK

For investors willing to accept a moderate degree of risk, advisers suggest focusing on bonds with ratings among the highest few grades of AAA and AA from rating agencies Standard & Poor's and Moody's. They also prefer bonds maturing in three to seven years versus the 10-year to 20-year bonds many investors own.

Fund investors should look for funds that have both those characteristics in addition to low fees and solid performance in varying market conditions, Todd Rosenbluth, a mutual fund analyst at S&P, said. S&P favors the American Century Intermediate-Term Tax Free Bond Fund, he said.

The fund charges 0.47 percent, about half the average for similar funds, and gained an average of 4.11 percent annually over the past three years, Rosenbluth noted.

"This is a fund with a good record during the boom and then during the bust," Rosenbluth said.

OPPORTUNISTIC MUNIS

The twists and turns in the muni market over the past few years have also occasionally created unusual circumstances that attract more aggressive investors.

Bonds issued by the public healthcare sector, for example, have sunk dramatically in price in recent years because of the declining finances of inner-city hospitals. But now some chains are being acquired by for-profit hospitals, drawing the attention of fund managers like John Loffredo of the MainStay Tax Free Bond Fund.

Since for-profit hospitals generally cannot issue tax-exempt debt, they are required to redeem or defease outstanding muni bonds from the non-profit chains they acquire. In a defeasance, the hospital must buy Treasury bonds sufficient to cover all remaining interest and principal payments of a muni bond. And once the munis are backed by Treasuries, prices can skyrocket.

For example, Vanguard Health Systems recently bought the Detroit Medical Center and had to defease the Michigan non-profit's outstanding tax-exempt debt.

Detroit Medical's long-term bonds, which traded at 72 to 75 cents on the dollar before the deal was announced last March, rose to 99 to 100 by the end of the year.

"With healthcare reform and the pressure on hospitals, there's a huge amount of consolidation that will happen," Loffredo said.

Still, Loffredo said he would stay away from lower-rated hospital bonds that might be too weak to hang on for an acquisition. "Our focus is on security selection," he said. "I would still be very careful."

(Editing by Padraic Cassidy)

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