After Detroit, muni bonds are safe, but no slam dunk

CHICAGO Tue Jul 30, 2013 10:29am EDT

'Detroit' is seen on the top of an iron man-hole cover on a street in Detroit, Michigan July 27, 2013. REUTERS/ Rebecca Cook

'Detroit' is seen on the top of an iron man-hole cover on a street in Detroit, Michigan July 27, 2013.

Credit: Reuters/ Rebecca Cook

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CHICAGO (Reuters) - Despite the Detroit bankruptcy and record sell-off of municipal bonds this year, most top-quality "munis" are safe to hold.

If you are a conservative, buy-and-hold investor who wants to temper risk, you might want to stick to the highest-rated bonds from states and localities that do not have looming pension or other payment problems.

Those quality munis offer decent yields and their prices are even more attractive in the wake of the Detroit bankruptcy.

Reacting to higher interest rates and the high-profile troubles of some states and cities, investors have been pulling out of muni bonds and the mutual funds and exchange-traded funds (ETFs) that hold them. They withdrew $1.2 billion out of U.S. municipal bond mutual funds in the week ending July 24, according to Lipper, a Thomson-Reuters company; more than $20 billion has been withdrawn in the second quarter of this year.

Muni-bond ETFs have taken their lumps of late because of the sell-off. The iShares S&P National AMT-Free Muni Bond ETF (MUB), which invests in an index representing the U.S. muni-bond market, for example, is down 4 percent for the year through July 26 and off more than 6 percent over the past three months. It is yielding nearly 2 percent.

A similar fund - the SPDR Nuveen Barclays Capital Municipal Bond ETF (TFI) - is down 4 percent for the year through July 26 and lost 6 percent over the past three months. It is yielding nearly 3 percent and charges 0.23 percent for annual expenses.

Both funds are good proxies for the U.S. muni bond market and worthy portfolio holdings, but that doesn't mean they are immune from interest-rate risk.

Like most bond prices, muni prices drop and yields climb when interest rates rise. Investors drop lower-yielding notes to chase higher yields. "Munis often take their cues from (U.S.) Treasuries, and when the 10-year jumped so did their yields," Jeff Tjornehoj, head of Lipper Americas Research, told me.

Investors may like finding the higher yields, but issuers feel the pain in terms of higher borrowing costs. States like Illinois and California, already straining under tens of billions of dollars of pension-fund debt, have to pay more to finance that debt when rates rise, further straining their budgets and ability to repay.

The sluggish economy may also hamper the ability of taxing bodies to collect taxes and pay bondholders, and that - along with tighter federal budgets - could continue to pressure issuers, according to Warren Pierson, senior portfolio manager with Baird Advisors in Milwaukee. He pointed out in a July 19 research report that six municipalities are now downgraded by credit analysts for every one that is upgraded; state downgrades outnumber upgrades 4-to-1.

Although many market watchers say that the bond-market sell-off last month might have been an over-reaction to Federal Reserve statements that it will soon back off its easy-money program - a position it softened two weeks ago - it pays to be cautious when purchasing muni-bond funds.

These vehicles may hold a number of bonds not only prone to potential defaults, but highly interest-rate sensitive. No one has said that interest rates won't climb again as the economy heats up or Fed changes its policy.

With most bond funds, if you want to stem interest-rate risk, the best way to do that is through shorter maturities, which are less sensitive to rate increases than longer-maturity notes.

The iShares S&P Short-Term National AMT-Free Muni Bond ETF (SUB), is down less than 1 percent over the past year and over the past three months, through July 27. The trade-off for its stability is lower yield - currently it is less than 1 percent; expenses are 0.25 percent annually.

You can find a slightly higher yield in the SPDR Nuveen Barclays Capital Short-Term Muni Bond ETF (SHM), which is yielding just over 1 percent. Like the iShares fund, the SPDR ETF has lost less than 1 percent in the yearly and three-month periods through July 27 and charges 0.2 percent annually in expenses - a slightly better deal than the iShares fund.

ON THE SAFE SIDE

For those investing in individual bonds, to stay on the safe side, choose non-callable bonds with the highest credit-quality ratings - "A" or better.

With lower-rated bonds, there's a higher risk of default. My home state of Illinois, for example, has the lowest credit rating in the country - ratings agency Standard & Poor's gives it a "BBB" rank ("AAA" is the highest) - due to the state's $97 billion pension liability.

A registered investment adviser, chartered financial analyst or certified financial planner can help you vet single bonds for your portfolio. If you need tax-free income and want a more diversified approach, mutual funds or ETFs are still worth holding.

Just keep in mind that higher yields come with much higher risk, which doesn't seem to be going away - even in an improving economy.

(The author is a Reuters columnist and the opinions expressed are his own. For more from John Wasik see link.reuters.com/syk97s)

(Follow us @ReutersMoney or here Editing by Linda Stern and Maureen Bavdek)

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