Could Your Munis Default? 5 Tips for Finding Safety

Repeat after me: Tax-free municipal bonds rarely default. It's unthinkable for a state not to pay the interest on its debt.

Then pause for a moment. Is anything really unthinkable anymore? You buy munis for security. Some of the bonds you're holding, in a mutual fund or an individual portfolio, no longer measure up.

General obligation (GO) bonds are always assumed to be super-safe because they're backed by taxing power. In some states and cities, however, you have to ask, "What taxing power?" Dysfunctional legislatures (think California and New York) are doing as much damage to state budgets as the Great Recession did. If taxes can't be raised and spending becomes too painful or irresponsible to cut, options are few.

States aren't allowed to go bankrupt. In a fiscal firestorm, default would become the only option.

You might assume that the federal government will bail out any big state in terminal trouble. That's the opinion of the sainted Warren Buffett. Having saved the big banks, Chrysler, and General Motors, Obama would have a hard time telling the states to drop dead, Buffett says.
As usual, he was talking his book. Buffett's portfolio includes munis valued at more than $3.9 billion as of the end of last year, Bloomberg Businessweek reports, and up to $16 billion in derivatives tied to such debt. It's not known how much of that money lies in the riskiest bonds or what Buffett's leverage is. But his words induce complacency. You'd be willing to sit on the bonds of states drowning in red ink (and paying higher interest rates) if you were pretty sure that the feds considered them too big to default.

That's a dangerous choice. Anything that the feds do for one state they'd have to do for others, which would turn into a bottomless and politicized spending pit. What's more, rescue would dampen any pressure on irresponsible voters and legislators to reform. (Remember -- it's ultimately voters who prevent budget compromises from going through.)

A Chapter 9 bankruptcy is an option for cities and counties, as a last resort. None of them could expect federal help. Holders of their GO bonds would probably get their money back, but not necessarily when they expected. Vallejo, California's bankruptcy filing proposes a three-year moratorium on principal and interest on $35 million in municipal debt.

I asked bond expert Marilyn Cohen, founder of Envision Capital Management in Los Angeles, what investors should do. I've never heard her sounding so pessimistic. "Sovereign debt implosion, starting in Greece. Next stop: municipal debt implosion," she said. Here's her five-point advice:

1. Holders of GO individual bonds should sell, or avoid, or minimize their exposure to, the bonds of the riskiest states. This includes not only such well-known basket cases as California, Ohio, and New York. She also warns against the eight states that couldn't afford to pay any more than one-third of their pension liabilities this fiscal year: Connecticut, Illinois, Kansas, Kentucky, Massachusetts,Oklahoma, Rhode Island, and West Virginia. Within those states, however, individual cities might be strong.

On her winners list she puts the bonds of Georgia, Minnesota, Missouri, North Carolina, Tennessee, Texas, and Virginia, with maturities of 10 years or less.

2. In the riskier states, muni bonds backed by solid revenue sources, such as sewer and water in well-established communities, might be better bets than the GOs. Weed out bonds that depend on discretionary spending or non-essential services, such as sports arenas, nursing homes, real estate developments, and hospital additions.

3. Buyers of muni mutual funds should choose investment-quality national funds rather than funds that own only the securities of your own state. Diversification frees the managers to choose among the strongest issuers. Your state usually taxes the interest you earn on out-of-state bonds, so you're giving up some net yield in return for feeling more secure.

Don't be fooled by investment-grade funds boasting higher-than-average yields. They're trying to attract you by tucking riskier bonds into their mix. Chasing yields is never smart. So far in 2010, the average yield on investment-grade funds is 2.5 percent, Morningstar reports.

4. Choose high-quality funds over high-yielding junk-bond funds. The junkers yield an average of 4.7 percent. In return for taking that risk, you'll get some defaults as well as potential big drops in price if a large municipality goes into Chapter 9. Jefferson County, Alabama, is the current leading candidate for municipal diaster. In Los Angeles, former mayor Richard Riordan is warning that bankruptcy might become the city's only sensible choice (the current administration says he's got his numbers wrong).

5. Consider buying corporate bonds instead of munis. "I never thought I'd say this, but corporates are a safer place," Cohen says. There's tons of cash on their balance sheets, they've paid down high-interest debt, and improved their debts' maturity schedule. The average investment-grade corporate fund yields just 3.5 percent taxable-okay for tax-deferred retirement accounts but a downer for taxable investors. Cohen is philosophical. "In the end, you'll say to yourself, 'I paid extra taxes but at least I weathered the storm.'"

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