By John Wasik
CHICAGO Oct 15 If you can avert your eyes from
the federal government's budget and debt-ceiling crisis, you may
spot more trouble ahead in the state and local municipal bond
Detroit's bankruptcy, Puerto Rico's fiscal woes and unfunded
pension liabilities in other states and cities are giving the
nearly $4 trillion muni bond market the jitters. Investors have
been yanking money out of muni bond funds for more than seven
months - triggering redemptions of almost $50 billion since
March, according to Morningstar.
That beats the nearly $45 billion in outflows from November
2010 to August 2011, when some soothsayers were predicting
massive defaults based on weakening state and local finances and
pension liabilities. And the exodus is far from over as the muni
bond market heads for one of its worst years in the past half
If you're an income-oriented investor in this market, it's
high time to look for safer ground. You need to be conscious of
credit quality, the fiscal condition of the bond issuers in your
portfolio and maturity dates.
The tried-and-true route is to go short on maturities and
high on credit quality. Bonds that mature in under three years
have the least amount of risk and volatility, though they also
pay the lowest yields. Exchange-traded funds and mutual funds
offer you a basket of different issuers, so you avoid
concentrating too much risk in a small number of bonds.
One fund that invests in short-maturity munis is the iShares
short-term National AMT-Free Municipal Bond ETF, which
invests in an index of short-maturity bonds.
With a yield just under 1 percent, the iShares fund charges
0.25 percent annually for expenses. The fund has gained 0.26
percent, compared with a 2.6 percent loss for the Barclays
Municipal Total Return Index through Oct. 14.
A worthy alternative is the SPDR Nuveen Barclays Capital
Short Term Muni ETF, which offers a slightly higher
yield at 1 percent and slightly lower expense ratio at 0.20
percent. It's up 0.02 percent for the year through Oct. 14.
As always, credit quality is also critical to avoiding
possible defaults. You have to concentrate on issuers who are in
good financial shape in areas that support economic growth.
Marilyn Cohen, co-author of "Surviving the Bond Bear Market"
and chief executive officer of Envision Capital Management in
Los Angeles, suggests sticking with the best-quality bonds rated
AAA down to A-.
"You aren't getting paid enough to go into low credit
quality," she says.
Use more than one broker to seek out munis, she says,
because prices and yields can vary from broker to broker by 1
percent to 5 percent.
What kinds of individual bonds offer the lowest default
risk? "The safest municipal bond investments are crème de la
crème credits," Cohen says. They include "essential-service
water, sewer and irrigation munis in good areas with growth."
Other strong issuers include "essential large airports;
senior liens and issuers that didn't buy Wall Street's
interest-rate swaps," she says.
AVOIDING TROUBLE SPOTS
The Detroit bankruptcy is the most high-profile trouble spot
in the muni market, and it's worth watching carefully as a sign
of things to come. That's assuming, of course, that the big
gorilla issue of Congress potentially breaching its debt-ceiling
deadline on Oct. 17 doesn't sabotage global credit markets.
How will the bankruptcy court treat the Motor City's general
obligation bonds? If it's decided that creditors will get only
pennies on the dollar, that could hurt other city-issued bonds,
especially those with large pension debts such as Chicago's.
During the past decade, general obligation bonds, which are
regarded as the safest issues, represented 60 percent of the
total muni market. What will happen to Chicago bonds if Detroit
is allowed to write down its general obligation debt? Puerto
Rican bonds are also in trouble; the U.S. territory has $70
billion in debt and holds an estimated $33 billion in pension
As if that weren't enough to worry about, you also need to
keep an eye on the Federal Reserve's interest-rate policy.
If the Fed decides to "taper," or back off its easing policy
of buying Treasury bonds, that could lead to another round of
interest-rate increases. That, in turn, could trigger another
round of muni selloffs and punish those holding higher-yielding
bonds and investors in ETFs and mutual funds, especially funds
that hold intermediate- to long-maturity bonds.