CORRECTED-YOUR PRACTICE-Reassuring clients during municipal meltdowns

Sat Aug 3, 2013 12:35pm EDT

(Corrects name of company to Build America Mutual in last paragraph.)

By Jennifer Hoyt Cummings

NEW YORK, Aug 2 (Reuters) - While U.S. municipal bond investors wait to see how Detroit's bankruptcy filing plays out, advisers should be calming them while taking a hard look at their portfolios.

Some prognosticators say that if the bankruptcy court treats Detroit kindly by allowing it to shed a lot of its liabilities, other troubled cities will follow its lead.

Others disagree, saying Detroit's Chapter 9 bankruptcy, filed on July 18, may drag on for years and lead other cities to think such a move is not worth the trouble.

"This will be precedent-setting for the municipal bond market," said David Kudla, chief executive officer of Mainstay Capital Management LLC, which is based 60 miles outside of Detroit.

While things are in limbo, many investors are taking their money out of U.S. municipal bond funds. They withdrew $2.24 billion in the week ended on Wednesday, extending the funds' outflow streak to 10 weeks, according to Lipper, a Thomson Reuters company.

These skittish investors may be acting prematurely, many municipal bond experts say, so it is up to advisers to give clients perspective while also reviewing their holdings to make sure there will not be any surprises.

"Now is the time for the adviser to earn their fee," said Gene Goldman, vice president of research for the El Segundo, California-based financial services company Cetera Financial Group.

PEACE OF MIND

Remind clients that municipal bonds have very low default rates. A May report by Moody's showed that the average 10-year default rate on municipal bonds was 0.12 percent, compared with 11.8 percent on corporate bonds. And of the 7,500 municipalities with bonds rated by Moody's, fewer than 40 are below investment grade.

Overall state tax collections are still weak, but they had risen for 13 consecutive quarters through the end of March, according to The Nelson A. Rockefeller Institute of Government. Housing prices are also on the rise, a boon for property taxes.

John Dillon, chief municipal bond strategist for Morgan Stanley Wealth Management, said that while yields had risen on longer-term munis, he saw compelling opportunities in the five-to-11-year range.

"While certainly Detroit is the 800-pound gorilla in the room," Dillon said, "the state of municipal credit has actually been improving."

DUE DILIGENCE

Advisers who place clients in individual munis should be doing comprehensive due diligence as a matter of course. And advisers who place clients in bond funds should become more of a watchdog over the managers of those portfolios.

Start by reviewing the holdings of the fund online or in the annual reports and prospectuses. Make sure there is a good mix of municipal bonds by geography, maturity dates and sector.

Consider each bond's type. It may be a revenue bond, backed by a specific project, or a general obligation bond, guaranteed by tax revenues and generally seen as the safest muni bet.

Figure out if a fund is overweight in an area by comparing the holdings with that fund's benchmark, which in some cases may be the Barclays Municipal Bond Index.

Go to the fund's own website and see the latest market commentary from the managers. Many big firms have quarterly conference calls, so hop on them and grill the managers about their analysis.

Cetera's Goldman suggests a good question for them: What is your least favorite holding, and why do you own it?

Get familiar with their research methodology. Goldman recommends using a firm whose analysts go to city hall to get financial statements and study traffic patterns before investing in a bond used to finance the construction of a bridge or roadway.

If the fund manager does not have time to answer all your questions, talk to your wholesaler, suggests Alan Dalewitz, senior vice president with Fairfield, Connecticut-based Herbert J. Sims & Co, an underwriter of tax-exempt bonds.

It may sometimes seem like a good idea to buy only insured bonds, but they may be tough to find. In the first half of this year, just over 3 percent of newly issued municipal bonds were insured, down from 57 percent in 2005, according to Thomson Reuters.

Check to see if the fund has insurance on bonds in high-risk areas, such as Illinois, which has well-documented budget problems, Dalewitz says. But then take that protection with a grain of salt, because this insurance could not always be relied upon in past crises.

Patrick Stoffel, municipal analyst with Wells Fargo Advisors, said he would not generally recommend buying bonds in a declining credit situation - like when there has been a significant downgrade and no clear solution to the municipality's problems, even if there is insurance.

The top-shelf credit ratings of several bond insurers were slashed during the economic crisis because of their ventures into mortgage-backed securities in the years leading up to 2007. This dried up the supply of bond insurance.

But there are signs that the market is opening up again, with new players venturing into the market, like Municipal Assurance Corp, an Assured Guaranty Ltd unit that only insures muni bonds, and Build America Mutual. (Reporting by Jennifer Hoyt Cummings; Editing by Linda Stern and Lisa Von Ahn)

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