Harrisburg not a meltdown for munis

THE ISSUE: Harrisburg, Pennsylvania filed for Chapter 9 bankruptcy on Wednesday, leading to questions about how other municipal bonds might be affected.

By Sam Forgione

NEW YORK (Reuters) - Municipalities across the country face budget woes, but few are expected to follow in the Pennsylvania capital city's footsteps.

True, municipal bond downgrades are on the rise this year. But defaults remain rare and represent a small share of the $3.7 trillion municipal bond market. Just $1.1 billion dollars in outstanding debt have defaulted this year, according to Lipper Research Services.

In a market environment where yield is hard to find, intermediate-grade muni funds have had a total return of 5.33 percent this year, without figuring in any tax advantage, according to Lipper. Top-rated munis total returns, meanwhile, have been just over 4 percent.

Concern over the fiscal health of U.S. states and cities has boosted yields over levels of past years. But the overwhelming majority continue to pay down their bonds -- and strategists see muni opportunities for judicious investors.

STEADY MUNI ETFS

Funds offer safety by not putting too much cash in any one place. Moreover, A-rated muni ETFs will completely avoid bonds issued by credit-impaired cities like Harrisburg.

"It would not have qualified for these ETFs," said Tom Lydon of etftrends.com. The city's $69 million in water refunding bonds are rated Ba1, several steps down from an A rating, and were put on review for possible downgrade earlier this month.

Lydon list four ETFs in his safe category: iShares S&P National Muni Bond Fund, SPDR Barclays Capital Short-Term Muni Bond ETF, SPDR Barclays Capital Muni Bond ETF, and PowerShares Insured National Muni Bond Portfolio.

Dave Fry of fund analysis Web site ETFDIGEST.COM said it's best to play safe."I would avoid a long-maturity, high-yield ETF because the risk/reward is not good."

The key with funds is that they can spread out the risk posed by a single city's failure to pay. But investors should look at the fund prospectus before leaping.

"Any more than 50 percent of a portfolio in a single state shows a lack of diversification," said Alan Schankel, a bond market analyst at Janney Montgomery Scott.

MUNI FUNDS

Hugh McGuirk, who heads the municipal bond team at T. Rowe Price said municipal bond fund investors won't see any impact from the Harrisburg bankruptcy because the city is a small issuer of debt - its bankruptcy filing stemmed from $300 million debt from a failed incinerator project.

Indeed, some strategists say the current slump in muni prices might be coming to an end soon. That means those unusually fat yields could slim down and bargains will be harder to find.

"Premiums for munis are at historically cheap levels," said Jerry Paul, chief investment officer of Essential Investment Partners.

Typically yields for munis are below treasuries because investors can get valuable tax breaks. Right now the current muni/treasury ratio is 120 percent, meaning they offer 20 percent more yield. The ten-year average of 88 percent, meaning their yields were 12 percent lower.

"They have gotten as cheap (in price) as they are going to get in this cycle, and they are going to get more expensive," said Schankel. As their prices rise, yields will fall.

Paul sees promise in inexpensive national funds like Fidelity Tax-Free Bond Fond or the Vanguard Florida Long Term Tax-Exempt Fund.

LOOKING FOR REVENUE STREAMS

Debt that is linked to specific projects is seen as better protected than the general debt of municipalities. These revenue bonds are paid with "ring-fenced" cash streams from such things as highway tolls or parking fees. General obligation bonds, on the other hand, depend upon elected government officials' taxing authority to pay off the bonds.

Timothy Pynchon of Pioneer Investments, invests long in "essential-need projects" such as hospitals, nursing homes, charter schools, airport bonds. "You know what you own," he said.

Domenic Vonella, a market analyst for Thomson Reuters, said even lottery bonds are considered safer. Florida state Board of Education lottery revenue bond bonds of 2021 were recently yielding 3.25 percent.

THE SAFETY OF 'AAA' ROADMAP

It's hard to avoid the obvious learning moment provided by Harrisburg. The Pennsylvania capital city's bankruptcy offers a fresh lesson to investors that states will not automatically intervene to assist cities. So investing in more financially sound communities is probably the best route for most investors. The extra yield of lower-rated issues may not be worth the anxiety, some strategists say.

Joshua Laurito, co-founder and principal of market data provider Lumesis, said for more general investment without the headache of sussing out the minutiae of city soundness, he likes investing long in AAA-rated general obligation bonds.

Top rated 10-year munis currently yield 2.58 percent on MMD's benchmark triple-A scale.

(Reporting by Sam Forgione, Chip Barnett, Linda Stern and Mike Tarsala; Editing by Jennifer Merritt and Richard Satran)

(This story corrects a quote in paragraph eight. Fry did not say that high-yield long dated ETF1 were low-risk option)