Personal Finance: Defusing the fear of muni bonds

Investors are panicky about losing their money in municipal bonds and have been calling their financial advisers for assurances since a recent 60 Minutes episode predicted massive bond defaults by local governments over the next 12 months.

"When people hear defaults, they imagine bankruptcy like a Madoff event, with their money gone," said Lewis Altfest, a New York financial adviser who has been getting some of those nervous calls. "It's difficult for individuals psychologically because they think of bonds as their safe area, their no-worry zone."

Instead of safe, financial analyst Meredith Whitney said on 60 Minutes, there "is not a doubt in my mind" that there will be defaults, perhaps totaling hundreds of billions of dollars, because many states, cities, and counties can't pay their bills.

Whitney commands attention because she ignored Wall Street's smiling faces before the 2008 financial crisis and detailed the underlying banking messes that led to a near-collapse of the system. Now, she said, the economy is threatened by ongoing declines in housing values and unwillingness by states, counties, and cities to take their financial problems seriously.

Since Whitney's interview, critics have challenged the size of her default prediction, but they do not argue with her underlying concern: For a decade or more, many state and local governments have pretended they could afford pension promises and they spent without coming to grips with how they would pay.

What isn't likely, she and other financial advisers say, are massive defaults, especially in state general-obligation bonds. A default could end up meaning anything from missing a single interest payment while an insurance company covers investors, to actual losses.

For example, Orange County, Calif., filed for bankruptcy protection in 1994, the largest municipality ever to do so. But within 18 months it covered the $880 billion it owed bondholders, providing 100 percent of what they were owed.

Bonds lose value if there is a default: Moody's notes that 30 days after a default, the average municipal bond has dipped from par at $100 to $59.91. That's bad, but not the "zero" that people might assume.

Still, not all municipal bonds are in danger. Generally, financial advisers say general-obligation bonds issued by states are among the most reliable. And bonds backing projects such as nursing homes or hospitals would be among the riskiest because the revenue stream is less predictable than, say, a utility's.

Beyond those generalizations, separating the risky from the safer bonds takes work. For example, Envision Capital president Marilyn Cohen, co-author of Bonds Now, says she will not buy general-obligation bonds issued by Illinois because of severe problems, but she likes general-obligation bonds issued by stronger states such as Texas, Virginia, Tennessee, and Wisconsin.

Some local governments are weak because states are slow at passing along money to them; other local governments have the benefit of more employed taxpayers and strong companies.

Among local bonds, those for essential services such as water and sewer are considered the most reliable. That is because people pay regularly for water and sewer service, and the revenue from those payments goes to bond investors. Still, Cohen avoids essential-service bonds in areas with high foreclosures.

Picking bonds "is like walking through a briar patch," she said.

To avoid any risk, Diana Joseph, chief investment officer of Barrington Strategic Wealth Management, is investing only in "prerefunded" bonds that put money in escrow to pay bondholders. Yet, because they are safer, they pay little interest.

Given the uncertainty of the times, Joseph has been investing less in municipal bonds and more in top-quality corporate bonds rated "A" or "AA" because publicly traded companies reveal more about their finances day in and day out.