Muni market offers opportunities despite budget woes

BOSTON (Reuters) - Despite the financial troubles of states and municipalities across the United States, financial advisers and mutual fund managers agree that the risk of wholesale municipal bond defaults is minuscule. In fact, new buyers are stepping in to take advantage of enticing bond yields.

"We do have some problems out there, but not anywhere as significant as some have portrayed," said Thomas Metzold, co-head of municipal investing at money manager Eaton Vance Corp EV.N in Boston. "Professional investors aren't selling bonds. We know it's overstated."

With tax revenues down dramatically from a few years ago, states, municipalities, and school districts are slashing budgets by laying off teachers and firefighters, closing libraries and canceling road repairs. But almost none of them are so strapped for cash that they have stopped paying interest on their debt.

The state of California gets most of the attention, with its gaping $19 billion budget deficit and lack of a final budget more than a month into the new fiscal year. But California’s recent debt issues have been well-received by institutional buyers. It also offers some of the biggest opportunities to income-hungry individual investors.

For an in-state resident in the highest state and federal tax brackets, the after-tax equivalent yield on California’s 30-year general obligation bonds can top 8.5 percent.

The high yields relative to Treasuries have attracted some unusual buyers that are not even interested in tax-free interest. At money manager Franklin Resources Inc BEN.N, not just muni funds are buying California debt. It has also attracted a rare cross-over buy from the massive $53 billion Franklin Income Fund, which typically buys only taxable bonds, said Rafael Costas, co-director of the firm's muni department.

“The risk of not getting paid is so infinitesimal,” Costas said, noting that the state continues to easily cover its debt obligations.

Still, investors looking at individual bonds should shop carefully in the current tax-exempt market to avoid problems, financial advisers say. Savvy shoppers may find some bargains as well.

One of the safest sectors within the muni market includes bonds backed by water and sewer fees, advisers say. Most people continue to pay their water bills, even when they lose their jobs. And water authorities tend to have far more cash flow than they need to meet their debt obligations.

“Our favorites are sewer bonds. Even in a difficult economic time, folks still need to flush their toilets,” said Lynn Ballou, a financial adviser at Ballou Plum Wealth Advisors in Lafayette, California.

Many bonds backing important municipal facilities like airports and hospitals are also a good bet, says Richard Ciccarone, who heads municipal bond research at McDonnell Investments in Oak Brook, Illinois. Ciccarone cites 20-year bonds backed by San Francisco’s airport that yield 5.40 percent.

Some advisers suggest that individual investors stick to more diversified funds instead of selecting their own portfolio.

“I’d much rather trust the credit analysis of experienced bond managers rather than rely on my own research,” said adviser Cliff Caplan, president of Neponset Valley Financial Planners in Norwood, Massachusetts.

Investors seem to agree. They’ve been pouring money into municipal bond funds. Thanks to inflows, along with strong market performance, municipal funds had record assets under management of $343 billion for the week ended August 4. One year ago, municipal bond funds had total assets of $254 billion.

Among mutual funds, Caplan prefers offerings from Legg Mason Inc's LM.N Western Asset unit, Eaton Vance, Thornburg and Deutsche Bank's DWS line of funds.

Jerry Paul, chief investment officer at Essential Investment Partners LLC in Denver, says investors can take advantage of market inefficiencies in closed-end muni funds.

Closed-end funds issue a fixed number of shares and trade on an exchange. That means the share price can get out of whack with the value of a fund’s underlying holdings, creating a bargain opportunity.

One short-term play that Paul is buying is the BlackRock California Investment Quality Municipal Trust RAA.P. The fund is trading at a discount to the value of its holdings and yields over 5 percent tax free. But holders will vote on liquidating the fund next month, which could cause the share price to rise and eliminate the discount.

“The California risk is reduced by the high likelihood of liquidation over the next few months, which gives us a chance to review the situation,” Paul said.

Reporting by Aaron Pressman and Lauren Young; editing by Jeffrey Benkoe