Municipal bonds: an investment with civic pride

Muni issues grow in turbulent times, offering higher yields.

With stock markets swinging wildly and credit markets trying to claw their way out of an icy freeze, investors have been searching for stability anywhere they can find it.

But the quest for financial security does not mean investors have to jettison moral values or bypass opportunities to make a difference. Instead, money managers and observers say, they can earn steady returns – and supply much-needed cash for public services – by investing in municipal bonds.

Muni-bond yields have reached historic highs this fall relative to US Treasury Bonds, which traditionally pay higher interest rates than munis. Since jittery investors have been shy to step up, yields on new muni issues have recently climbed to pay as much as 50 percent more than Treasury bonds.

As a result, investors have been finding high-quality, long-term bonds rated "A" or higher that pay a handsome 6 percent and more in tax-exempt income.

"If you look from a historical perspective at what tax-free bonds are yielding right now, it's a great time for individual investors to be starting to look at individual bonds," says Monte Avery, who manages seven state-specific, municipal bond funds for Integrity Mutual Funds of Minot, N.D.

For investors eager to address civic needs through their investments, munis hold a particular appeal. States and localities depend on the $2.66 trillion muni market to finance everything from bridge repair to school construction and water-system upgrades.

"Municipal bonds allow individuals to get involved in their local communities to help build a school, a hospital, or some infrastructure … so there is a strong social component," says Paul Sutherland, a Traverse City, Mich., money manager for individuals and for Utopia Mutual Funds, which seek out "sustainable" investments. "Plus, a lot of people prefer municipal bonds over US government bonds because US bonds fund a lot of things that people don't want to support, such as war and activities that people might consider exploitative in other countries."

Now, with a nasty recession seeming to loom large, state and local government needs for investment capital are becoming especially acute. This month, investors helped avert a California government shutdown by buying up nearly $4 billion in "revenue anticipation" bonds over a 48-hour period. Also this month, individual investors snatched up most of a $550 million bond issue from New York City, which has recently tiptoed back into a previously frozen municipal bond market. Other cities, shaken by recent events, hope there's more cash where that came from.

Earlier this fall, "there was nobody willing to make a loan anymore on a short-term basis," says Chris Hoene, director of policy and research for the National League of Cities. "The big problem here [for many cities] is that the money is just not flowing."

If heartened by California's and New York City's successful offerings, more states and cities will be apt to issue short-term bonds as they cope with shrinking revenue streams, according to Kim Reuben, a public finance economist with the Urban Institute, a policy think tank in Washington, D.C. That could mean new opportunities for investors to help out in times of extraordinary need – and perhaps give their portfolios an overdue boost in the process. An investor who buys a muni through his or her home state usually receives an investment that's exempt from state as well as federal tax.

Opportunities notwithstanding, munis also come with risks, such as the possibility that they'll lose value in the bond market. From Jan. 1 through mid-October, munis' trading values have slid about 9 percent, according to benchmark indices. Worries about the solvency of certain municipal bond insurers have scared some investors away from this traditionally sleepy investment class. Add in this fall's liquidity crisis in credit markets, and the situation can still spell trouble for bond owners who must sell within a couple of years.

But observers say a few cautious rules of thumb, even in these turbulent economic times, can enable investors to use munis to help them sleep well at night.

One approach to limiting muni risk involves seeking out diversity. By buying into a municipal-bond mutual fund or an exchange traded fund (ETF) that tracks particular bonds or a bond index, investors spread their risk across many debtors in case one or more default. Sutherland is considering loading up on closed-end municipal bond funds if and when they start trading later this year at 15- to 20-percent discounts off their net asset values (NAV).

Discounts Mr. Sutherland has seen lately, as high as 28 percent off NAV in early October, suggest to him that "people are being completely driven by fear and not by any component of rationality."

Investors seeking meaningful social returns may want to buy bonds associated with particular communities or projects. Such debt instruments, picked up on favorable terms, can also give a portfolio more kick than a diversified bond fund. For minimizing risk in this domain, experts generally agree on two tips: 1) seek out highly rated bonds, such as A+, AA, or AAA, and 2) opt for "general obligation" rather than "revenue" bonds.

Certain revenue bonds can be risky because repayment depends on revenues generated from a particular project. On Ms. Reuben's caution list: Revenue bonds issued to build or expand regional airports in fast-growing areas. While such projects might evoke civic pride, they also might stumble if hard times lead to fewer fliers. Bond-holders could then get stuck holding unsellable paper.

General-obligation bonds, on the other hand, are backed by a government's tax coffers. That makes defaults highly unlikely, Reuben says, since even a financially troubled government can use its taxing authority to settle its debts.

"If you're getting 4, 5, or 6 percent [in tax-exempt yields], that's a pretty good return on something that's a really safe asset," Reuben says. "No state has really defaulted on general obligation debt, and it's very rare for there actually to be bankruptcies or defaults on local debt."

Still, investors may not wish to worry about delayed payments or other complicating factors. Such risk-averse types might consider avoiding bonds from communities hardest hit by the housing market downturn, Mr. Avery says. That's because falling home values may eventually translate into drops in property-tax revenues and financial strain for local governments. Better bets, he says for example, might be bonds from Midwest farming communities which have prospered with the recent run-up in agricultural commodity prices.

Others question whether insurance on a bond actually reduces risk. Kansas City money manager Stuart Speer says the financial crisis has led him to believe that "if a bond is insured, it would be riskier than if it were not insured." That's because if a credit-rating agency discovers subprime or other bad debt on an insurer's books, then it's apt to cut the insurer's rating, and all bonds insured by that company would consequently lose value on the open market.

Among the best moves muni investors could make to limit risk, money managers say, is to give themselves a long horizon. Planning to hold a bond to maturity, Avery says, allows a bond holder to relax even when a bond's trading value sinks in the short term. Such slides in value can happen with rising interest rates or other market-moving factors. When they do, muni investors need to be psychologically prepared.

"One of the side effects of having good long-term performance is that there is going be short-term volatility," Sutherland says. "That's a fact. It's reality. And you can't get around that."