The One Safe Way to Invest in Municipal Bonds Now

Late last year, outspoken banking analyst Meredith Whitney rattled the staid world of municipal bonds with a bold prediction on 60 Minutes that hundreds of billions of dollars in munis would soon default because of declining local tax revenues and expenses such as underfunded public pensions.

That prediction succeeded in scaring the small investor out of the muni market. According to market researcher TrimTabs, some $31.5 billion has been yanked from muni mutual funds since that fateful broadcast.

But Whitney's dire scenario hasn't come to pass: Are we out of the woods on the municipal bond front? And, if not, is it still possible to invest in that sector safely?

Pre-Refunded Munis: Your Payout Is Waiting

Marilyn Cohen, CEO of Envision Capital Management, a fixed-income management firm in Los Angeles, says it's still too early to invest anew in munis.

Sponsored Links

"I think we're going to have a second wave of selling," says Cohen, co-author of the new book, Surviving the Bear Bond Market. "I think the default rate in the next 12 months is going to be significantly higher than we've ever seen before, because the market has changed."

So what is a conservative investor to do, given that Treasuries are yielding almost nothing? Well, Cohen isn't spurning all munis. She recommends buying one select group that carry virtually no risk: pre-refunded munis, or escrowed to maturity bonds.

These bonds function exactly like regular munis, complete with the tax-free income. The only difference is that the money to pay off the principal and interest has been set aside in an escrow account.

There are several methods used to fund these escrow accounts, but Cohen recommends buying only pre-refunded munis that have U.S. Treasuries in the escrow. She says even though bonds issued by the government-run Fannie Mae and Freddie Mac mortgage issuers are sometimes used, investors should steer clear of those.

The only risk with these bonds is if the U.S. government goes bankrupt, and there's little risk of that, despite the budget battle in Washington.

Investing in the Real Necessities

Dick Bellmer, CEO of Deerfield Financial Advisors in Indianapolis, is also a fan of pre-refunded munis, noting that the more attractive ones are issued by budget-challenged states like California and Illinois. "People say 'I don't want one of those things,'" he says. But they still carry no risk, even when the issuing state's finances are a mess.

The only real drawback is that so many people have cottoned on to the fact that pre-refunded munis with U.S. Treasury escrow have essentially no risk that they are no longer such a great deal as they once were.

Consequently, Bellmer recommends essential revenue bonds as a possible alternative. These bonds are issued by states for such things as municipal water companies. "If they're going to cut off your water, you're probably going to pay your water bill," Bellmer says, "which means the risk as it relates to essential revenue bonds is probably not a lot of risk. You can still get a pretty decent yield off of those kind of bonds."

Bellmer cautions small investors to make sure the bonds they invest in are not illiquid, because few institutional investors can be bothered to get involved in $25,000 bonds. That means there may not be a big market for them, and they could prove hard to sell in a pinch. He prefers holding bonds to maturity, but not every small investor has that kind of flexibility.

Beware of the Price/Yield Dichotomy

Bellmer isn't a big believer in muni mutual funds: He prefers to hold individual muni bonds.

"I know exactly what I am going to get -- a stream of interest payments and the value of the bond back when it matures," he says. "With a longer-term bond fund, people are buying because it pays a higher interest rate."

But what they don't recognize is that when interest rates go up in the economy because of rising inflation, the entire value of the bond fund is going to go down since price and yield move in opposite directions.

Suddenly the higher-yielding fund doesn't look so good, Bellmer says. Then the only possibility of the fund rebounding is if interest rates go down again -- and that may be years in the future.