What the Harrisburg, Pa., bankruptcy means for you

The Pennsylvania State Capitol Building as seen from State Street in Harrisburg, Pennsylvania, October 12, 2011.

WASHINGTON (Reuters) - Wednesday's bankruptcy filing by Harrisburg, Pennsylvania, may create some turmoil for those focused on the city's budget, but individual investors with money in munis don't need to panic.

Most professional bond investors had spent the better part of the year distancing themselves from Harrisburg holdings, so they aren't held by big popular vehicles like Vanguard's tax-free bond funds.

"These bonds have been in the muni doghouse for a while," said Daniel Berger, senior market strategist at Municipal Market Data. "(The bankruptcy filing) is not news to most investors." Furthermore, much of the Harrisburg debt was insured.

Should investors worry about future defaults or buy more bonds? Here are some considerations:

-- Harrisburg bondholders will see money. "Virtually all of it has some kind of insurance on it," says Alan Schankel, a bond market analyst with Janney Montgomery Scott in Philadelphia. The incinerator-linked bonds were covered by Assured Guaranty, a Hamilton, Bermuda-based insurer, which has already made some payments that the city had skipped earlier, he said. Typically, insurers covering bonds pay out interest and principal on schedule as it becomes due.

-- Harrisburg may be unique. The city's whole budget is less than $60 million and it went more than $300 million in debt over a failed incinerator project. "This was an outsized obligation on their part that they shouldn't have done, but we haven't seen anything like this from other communities in Pennsylvania," says Schankel. "This is an isolated situation."

-- In fact, it could be a buying opportunity. Muni prices have been driven down (and yields driven up) for a variety of reasons. In trading on Wednesday, prices of tax-free bonds finished mostly lower, with yields on AAA-rated 10-year munis up 3 basis points to close at 2.53 percent on Municipal Market Data's benchmark triple-A scale. In contrast, yields on 10-year Treasury notes closed at 2.23 percent.

It's unusual that munis yield more than Treasuries. "They have gotten as cheap as they are going to get in this cycle, and they are going to get more expensive," says Schankel.

David Hultstrom, a fee-only financial adviser and analyst with Financial Architects in Woodstock, Georgia, suggested that munis and Treasuries are relatively mispriced. "In theory, you could short Treasuries and buy munis and wait for them to correct. I'll bet there are hedge fund managers out there doing that right now."

-- Fund investors needn't worry. "There should be no impact on muni bond fund investors," says Hugh McGuirk, who heads the municipal bond team at T. Rowe Price. "Harrisburg is not a significant issuer and their troubles have been well known for years. This was well anticipated by the market."

Fund investors at big companies like Vanguard and Fidelity can go online and see all of the holdings in their funds.

-- It may help to think in terms of dollars instead of yields. On paper, munis look good, because they are attractively priced relative to Treasuries, says Hultstrom. "But in actual dollars, all the yields are so low, so who cares?" For people looking to invest small sums, "the dollar amounts may not justify the added risks of investing in munis" says Hultstrom.

For the same reason, bond investors should focus on buying high-quality issues instead of squeezing out the biggest returns, says Joe Deane, executive vice president at Pimco. "Don't try to go for the highest yield out there."

-- Diversification continues to rule. Bond buyers should never over commit to any single issuer; that's bedrock bond advice. Even investors in high-tax states who like the triple tax-free nature of their local muni bonds should keep that to 50 percent of their own portfolio, suggests Schankel. "Any more than 50 percent of a portfolio in a single state shows a lack of diversification."

Drilling down to individual municipalities, investors are advised to keep their holdings of any one issuer to under 10 percent of their portfolio. Less than 5 percent is optimal, but investors with larger sums may find it hard to stay within that 5 percent limit, given the scant offerings of the market.

(Additional reporting by Jilian Mincer and Chip Barnett; Editing by Andrew Hay)