Also See: * How to Make Sure Your Bonds Are Safe * The New Bond Bubble
It looked like the closest thing you could get to a sure bet — even in a city full of one-armed bandits. The state of Nevada planned to build a sleek, automated monorail that would ferry millions of tourists up and down the famed Las Vegas Strip. And they were funding it by selling more than $600 million in municipal bonds — some of them paying a hefty 7.5 percent in interest. With AAA ratings, they were the very definition of “safe” muni bonds.
But something funny happened on the way to the casino. Fewer tourists came to Vegas, and those who did weren’t up for a train ride; the monorail brought in far less revenue than expected. The nonprofit monorail agency filed for bankruptcy-court protection earlier this year. As for investors, not only have their interest payments dried up — the project’s bankruptcy attorney confirms that it won’t make its next payment, on July 1 — but they could lose almost all of their principal. The stranded buyers include top fund companies like New York–based DWS Investments. Its $6 million stake was a tiny fraction of its $1.6 billion DWS Scudder Strategic High Yield Tax Free fund, but manager Phil Condon still seems flummoxed. After all, such a disaster in a highly-rated municipal bond is almost unheard of. “We’re not perfect,” Condon says.
Neither, it turns out, are muni bonds. A once-stable class of investments built on the nation’s roads, sewers and schools is beginning to look as shaky as, well, many of the nation’s roads, sewers and schools. In recent months, of course, investors have seen apocalyptic headlines about all kinds of government-issued bonds — starting with those from Iceland and Greece, foreign nations stuck with tremendous debt and nowhere near the revenue to pay it off. With California’s government issuing IOUs and other states and cities slashing services, there’s been plenty of reason for investors to feel nervous about the $3 trillion, U.S. municipal bond market. When they get anxious enough to ask their brokers about their Puerto Rico-sewer and Pennsylvania-turnpike bonds, however, they generally hear the same answer: It’s too soon to worry.
But investors are starting to see signs of deeper problems — hairline fractures in the muni market’s foundation. With the real estate crash and high unemployment robbing cities and towns of tax revenue, more municipalities are being forced to renege on their debts. Since last July, 201 municipal bond issuers have missed interest payments on some $6 billion worth of bonds, or an average of about one every other day. That’s up from 162 in 2008, and a hefty increase from the 31 that did in all of 2007. To be sure, most of these busted bonds are not of the caliber that most Main Street investors buy. But the tremors are enough to inspire jitters among money pros. Already, sober-minded bond analysts and even a few state officials are beginning to join the fringe doomsayers in warning that there’s potential for a municipal bond collapse. A small but growing number of financial advisers are uneasy too, telling clients to pull back a bit.
Whether those warnings are being heeded, though, is unclear. With their attractive and often tax-free yields, muni bonds have long been a draw for risk-averse investors, particularly retirees looking for a steady and reliable payment. Given how meager savings-account interest remains, it’s not surprising that investors are still pouring an average of nearly $800 million in new money into munis each week, on top of the record $70 billion they put in last year. What’s more, investors would need a keen eye to know the problem is escalating. After all, a missed interest payment on a bond in Beaumont, Texas, barely gets mentioned in Beaumont, let alone on CNBC. Mutual fund shareholders, meanwhile, would have an even harder time noticing a muni crisis at first. The impact of any single Vegas-style flameout is muted in a fund holding hundreds of bonds.
But pile on more defaults or other troubles, say skeptics, and prices in the whole category could plummet. If that happens, says Bob Froehlich, senior managing director of The Hartford, an insurer with a municipal bond portfolio of $12 billion, bond owners will have two choices: tie up their money for years by holding the bond to maturity or sell at a loss. “A lot of investors were naive, thinking, ‘It’s so safe, nothing can happen to it,’” Froehlich says. “It’s on-the-job training for a lot of investors.”
For today’s generation of advisers, witnessing a municipal bond default is on par with seeing a living woolly mammoth. From 1974 to 2009, the default rate on bonds rated “investment grade” by major credit agencies was 0.3 percent. (Corporate bonds defaulted five times as often over the same time frame, according to Moody’s Investors Service.) “For the most part, municipal credit is very sound,” says Jim Murphy, who oversees a $1.8 billion tax-free high-yield bond fund at T. Rowe Price. Bond investors often attach a stigma to a town that defaults on municipal debt, which means that if it ever wants to raise money again, doing so will be much more difficult — and expensive.
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