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There’s Turmoil in the Municipal Bond Market as Cities Struggle

Does this mean municipal bonds are no longer the "safe" investment they once were?

If you wanted to see your money grow without being clobbered by a hefty tax bill, Municipal Bonds were a good way to go. And in many cases they still are with their huge tax advantages that include exemption from federal, state and sometimes even local income tax.

Unfortunately, the muni bond market has been in a state of turmoil over rising uncertainty over the financial strength of some of the municipalities issuing those bonds. It has become a highly fractured market.

Prior to 2008, the muni world was homogenous. Many bonds were insured and considered safe. Today only about 7% fall into that category. The steady economic growth over the previous two decades meant government budgets were in good shape. But the financial crisis changed all that.

One way to look at it is that before the financial crisis there was one municipal-bond market and now there are more than 20,000. Usually, the muni market is steady. Lately, it's been anythingbut. The recent selloff has caused the Bank of America/Merrill Lynch Municipal Bond Master Index to fall 3.6% this month.

A number of factors are behind the mess and an unusual combination of events triggered a selloff. First, treasury yields rose and that led to losses on bonds across the board. Investors sold older bonds to make room for newer ones just as a large supply of muni-bonds hit the market. Then a number of states such as California found themselves staring at budget shortfalls and potentially being unable to meet pension obligations.

The financial crisis also drained the muni market of liquidity. Bear Stearns and Lehman Brothers were two major muni-bond dealers before they blew up. Other banks and brokers have been less willing to hold large amounts of muni bonds on their books, while some hedge funds that used "arbitrage" strategies in the municipal-bond market pulled back or disappeared.

Also, now that congress is back from vacation, there's the question of whether the Republicans will be able muster enough votes to end the Bush tax cuts for everyone, even the upper income Americans who use munis as much as anyone to reduce their tax bite.

The financial troubles of many municipalities, meanwhile, have created new winners and losers among different classes of bonds. Before the crisis, "general-obligation bonds," which are backed by the taxing authority of a state or city, were the top of the municipal food chain. It was thought that an issuer of a general-obligation bond would withstand tough times because of its ability to raise taxes to make good on their debt.

But since the start of the recession, unemployment has increased, reducing income-tax revenue. Add to that the fact that property values have plunged along with real-estate taxes. Plus, the American consumer is saving more and spending less which means sales-tax revenue is down as well.

With the market so fragmented, investors find it hard to value munis appropriately. They can't tell if the bonds are a good price or expensive.

When more of the muni market was insured, the direction of interest rates was the primary driver of yields. Treasurys and municipal bonds typically moved in the same direction, with a fairly predictable ratio between their yields. But now the direction of interest rates is just one of many drivers of muni yields, and there is very little relationship between Treasurys and munis.

Financial experts say muni investors who have been jarred by the recent volatility need to reassess their muni portfolio's quality and sensitivity to interest rate swings. With the expectation of rising interest rates, uncertainty about tax-law changes, and the uncertain financial position of many state and local governments, analysts expect the volatility to continue for some time.

While it still is worthwhile to hold high-quality muni bonds for income, investors shouldn't expect much in the way of price appreciation in the months ahead. And anyone holding individual muni bonds should consider selling their big winners now, particularly those with longer maturities. The upheaval of the past few years has made most muni bonds and funds a trickier investment.

For investors looking to exploit recent weakness, diversification is essential. With many state and local governments strapped for cash, investors should spread their bets widely among individual bonds even if it means giving up in-state tax benefits. 

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