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How to avoid municipal bonds that default

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Since the financial crisis, analysts have speculated on the degree to which municipalities and their ability to pay creditors would be hit. Unemployment, the foreclosure crisis and sprawling pension obligations have intensified the struggle in some areas — for instance, San Bernardino, Calif., and Stockton, Calif.

While default rates remain low, several high-profile bankruptcies have recently thrust municipal financing back into the spotlight. Though experts insist that the municipal bond market is generally safe, a recent report from researchers at the Federal Reserve Bank of New York may undermine those assertions in the minds of investors.

Defaults reported by credit rating agencies such as Moody’s don’t tell the whole story, as they only include rated bonds, according to the Fed researchers in their blog post titled, “The untold story of municipal bond defaults.” Including unrated bonds in the total number of defaults exponentially increases the number of defaulted municipal bonds.

Still a pretty low number

Consider the time period between 1970 and 2011: Over the 41-year time frame, Moody’s reported 71 defaults, while the economists at the Federal Reserve Bank of New York found 2,521 defaults. Meanwhile, Standard & Poor’s 500 index reported only 47 defaults since 1986, while Fed data show 2,366 since then.

But there is a reason unrated bonds have no rating. “They can’t get an investment-grade rating,” says Robert Doty, president of AGFS, a Sacramento, Calif.-based consulting firm to municipal securities issuers, and author of the “Bloomberg Visual Guide to Municipal Bonds.”

Unrated bonds comprise a small portion of the $3.7 trillion municipal bond market, but they account for most of the defaults, according to Doty.

“Somewhere around 20 percent of the bonds are responsible for 80 percent of the defaults. And 80 percent of bonds are responsible for 20 percent of defaults,” he says.

Most small investors concerned with credit risk should stick to rated bonds and, more specifically, general obligation bonds or traditional revenue bonds. In municipal bankruptcies, the types of securities at risk of default are “securities payable from community general funds. And that is not a general obligation bond,” Doty says.

“If you look at the nature of the credit behind Jefferson County, Stockton, San Bernardino, Orange County, New York City — all the spectacular defaults have been general fund obligations,” he says.

Bonds payable from the general fund are sometimes called special assessment bonds. Interest and repayment come from taxes on the neighborhoods benefiting from the projects the bonds fund. For instance, in 2011, Jefferson County, Ala., declared bankruptcy as a result of a sewer-system project run terribly amok.

Different types of muni bonds

There are many types of municipal bonds, but the broadest categories are general obligation bonds and revenue bonds. General obligation, or GO, bonds are backed by the credit of that state or local government and their ability to tax. They are not guaranteed. In some instances issuers can still default if they go into bankruptcy. But most issuers don’t want to go into bankruptcy because it will adversely affect their credit rating.

“The tax-free financing is a benefit. The problem is the bond market has a long memory. If you do jeopardize your financing, the market doesn’t forget. So the cost of financing going forward is very elevated for a long, long period of time,” says William Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass.

Revenue bonds are typically issued to fund specific projects and will be repaid by special taxes or by the revenue generated by the project — for instance, airports collect fees from airlines, and toll roads are paid by commuters who use them. Historically, the safest types of revenue bonds are traditional water and sewer revenue bonds.

Revenue bonds can be issued to finance hospitals, airports, telecommunications infrastructure, industrial development, higher education and power plants.

“It’s a very segregated income stream that you’re counting on,” says Marilyn Cohen, founder of Envision Capital Management in Los Angeles and author of “Marilyn Cohen’s Bond Smart Investor.”

Historically, general obligation bonds and traditional water-sewer revenue bonds have low default rates, but even there, investors must do their homework.

“If you buy essential-service revenue bonds, such as water and sewer, you’re going to be fine. But it depends on the area because if you buy water and sewer bonds in areas that have a high foreclosure rate, you need those hookups to continue to keep that income stream rolling,” Cohen says.

Yield goes with risk

While the majority of bonds in the municipal bond universe will be less risky, investors can get sucked in by high yields, and that is when things get tricky.

“You really have to be a professional to invest in that marketplace. An individual is much better suited to go into a mutual fund because a fund gives them a whole bunch of benefits,” says Larkin.

The benefits include a professional investment team well-versed in the market, diversification and monthly payments. But that’s not all.

“The most important thing that it gives them is liquidity. I always refer to (the municipal bond market) as a county road. The transactions are not very frequent, and liquidity can be a major problem because as a retail investor, you can get scared very easily and then try to sell. And that’s when you’re going to take your biggest loss,” Larkin says.

Closed-end muni bond funds

The fact that the municipal bond market is so illiquid can make closed-end funds more attractive to investors who might not otherwise consider them. But there are some drawbacks to closed-end municipal bond funds.

For one, most use leverage, which can amplify returns or, conversely, show dramatic losses quickly.

“These leveraged funds can be down 15 percent in a week if there’s massive selling,” says Cohen. “It’s not a passive investment: You have to be ready to eject when it’s time to eject,” she says.

Fees are another issue. They can be expensive, Cohen says. Investors should also try to buy them as close to the net asset value as possible or, better yet, below NAV.

Closed-end funds are traded on an exchange like stocks or exchange-traded funds, or ETFs. Unlike an open-end mutual fund, when the closed-end fund is created, a set number of shares is allocated, and the net asset value is established through an initial public offering. The difference between what people are willing to pay in the open market and the NAV indicates a premium or a discount.

Right now, there’s a high demand for yield, so many of the municipal bond funds are trading at a premium.

“Stick with the big providers — Black Rock and Nuveen — the big, big providers. And stay away from some of these closed-end muni funds that are selling at huge premiums. Some of these premiums are 10 (percent) or 20 percent over net asset value,” Cohen says.

The municipal bond market is complex and not without risk, and some sectors do have high default rates. But there’s nothing wrong with taking risks as long as you understand them — or if you have the right fund management team to understand them for you.