Municipal bonds traditionally have been a refuge for the risk averse, as many are backed by the full faith and credit of state and local governments, but those same investors lately have been bailing out at a record rate.

A few factors can be blamed for this sudden retreat, but the one making all the headlines is the fear that cash-strapped states and municipalities issuing the bonds will renege on promises to investors.

Those simmering concerns were stoked last month when respected banking analyst Meredith Whitney warned on CBS's "60 Minutes" that 50 to 100 or so cities and counties will default on "hundreds of billions of dollars" of municipal bonds.

Many bond experts scoff at Whitney's prediction, saying it's wildly off the mark. The worst year for municipal bonds in the past three decades was 2008, when 162 issuers defaulted on bonds totaling $8.1 billion - not hundreds of billions - according to the Distressed Debt Securities Newsletter, which tracks defaults.

Still, bond experts acknowledge that states and municipalities face severe financial strains. These experts don't suggest avoiding municipal bonds, but they say investors can no longer buy any old bond and assume their investment is safe.

"They have to be extremely picky," said Marilyn Cohen, author of "Surviving the Bond Bear Market," which is scheduled for release in March.

State and local governments issue municipal bonds to build schools, hospitals, roads and other projects. The bonds appeal to investors in higher tax brackets because the interest is generally exempt from federal taxes and - if the bond is issued within their home state - from state and local taxes, too.

Municipal bonds traditionally have low default rates, so investors rushed into them for safety and higher yields after the stock market crash in late 2008. But this past November, they started pulling out in big numbers.

Net outflows from municipal bond funds reached $7.9 billion in November, according to the Investment Company Institute. Estimated outflows last month hit $13.35 billion, a record in the 26 years that ICI has reported the figures.

Bond experts blame the exodus in part on rising rates on Treasuries, which caused investors to worry that the value of their muni bonds would fall and prompted some to seek higher returns elsewhere.

On top of that, it became clear near the end of the year that the federal Build America Bonds program wasn't going to be extended beyond 2010, said Hugh McGuirk, head of T. Rowe Price's municipal bond group. Subsidies from this stimulus program made it cheaper for states and local governments to borrow by issuing taxable bonds. With the demise of the program, more tax-exempt municipal bonds are expected to come onto the market and push prices down, McGuirk said.

Headlines about the financial problems of states and municipalities also likely added to investor anxiety. Pennsylvania's capital, Harrisburg, nearly defaulted on a bond payment last fall before the state came to the rescue.

Then last month Whitney made her dire prediction for the upcoming year on national TV. Ever since Whitney correctly forecast problems in the banking sector a few years ago, her observations have carried a lot of weight. She told "60 Minutes" that she doesn't expect any states to default, but that cities and counties would have sizable defaults. She reaffirmed her outlook last week on CNBC.

Mitch Schlesinger, chief investment officer at FBB Capital in Bethesda, says clients are concerned.

"And rightly so, given all the news that's going on in municipal finances" across the country, he said. He's not avoiding muni bonds but warns that "you have to be much more careful than in any time in the past."

Richard Lehmann, who publishes the Distressed Debt Securities Newsletter, agrees that defaults will go up this year. About 100 to 200 bond issues default each year, and "that is likely to accelerate now that municipalities have hit the wall," Lehmann says.

But he expects $3 billion to $5 billion in bond defaults, not hundreds of billions. "Anything above $2 billion is a high default rate," Lehmann said.

Many bond experts take issue with Whitney's forecast.

"Meredith Whitney should stick to evaluating bank stocks," said Dick O'Brien, an executive vice president with brokerage Folger Nolan Fleming Douglas Inc. Governments will do whatever it takes to avoid defaults so they can continue borrowing through the muni bond marketplace, he says.

"Governments are tightening their belts. They are raising taxes. There are all sorts of things that issuers can do prior to defaulting on their debt," O'Brien said. ("60 Minutes" also featured a clip of Maryland Gov. Martin O'Malley saying, "Cuts, cuts, cuts and more cuts.")

T. Rowe Price's McGuirk adds that even if defaults tick up, there are still plenty of choices for investors in the $2.8 trillion municipal bond market, which has at least 40,000 issuers. "It's a broad and diverse market," he said.

Still, you must do your homework before investing in an individual municipal bond - or make sure your adviser or broker has.
The website emma.msrb.org provides information on the initial bond offering, but you should also search online for news about the issuer, O'Brien said. Make sure you get the latest credit rating on the bond, too, he added.

There are two types of municipal bonds. General obligation bonds are backed by the state or municipality issuing them. Revenue bonds aren't backed by the issuer, but are repaid by the income generated by the projects they finance.

O'Brien predicts investors will flock to general obligation bonds from the most credit-worthy issuers, such as the state of Maryland.

But many bond experts recommend revenue bonds that support an essential service, such as water, utilities and airports. They advise avoiding bond issues whose income stream is less certain, such as those for nursing homes, apartment buildings and golf courses.

McGuirk said T. Rowe Price is more focused on revenue bonds for essential services. Meanwhile, it's avoiding general obligation bonds backed by Illinois because it's having more difficulty than others fixing fiscal problems. (Even the Illinois comptroller admitted on "60 Minutes" that his state is a "deadbeat.")

You also can leave all this homework up to a professional by investing in a municipal bond fund. A fund may hold securities from 100 or more issuers, so that if one defaults the impact is muted.

To be sure, bond funds also have risk. With an individual bond, you get the return of your principal once it matures. But bond funds regularly buy and sell bonds so there is no maturity date. You could lose principal depending upon the market when you sell.

"You need to be careful when you invest in anything," O'Brien said, "and municipal securities are no different."

Eileen Ambrose is a personal finance columnist at the Baltimore Sun. Send her e-mail at eileen.ambrose@baltsun.com. She cannot give individual advice.

(c) 2011, The Baltimore Sun.

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