A little more than a year after the first signs of mayhem in the municipal bond markets, issuers are still defaulting, and investors are still worried. And while investing professionals would say that in this climate, it’s best to leave your bond research to the experts, that’s not the only way: A little diligence, a free afternoon and an Internet connection is enough to start separating the risky munis from the stable ones.
The goal – to build a portfolio of municipal bonds that reduces risk and supplies steady tax-exempt income – is still possible, says financial advisor Dennis Gibb, president of Sweetwater Investments, an investment advisory firm in Redmond, Wash. By picking issuers whose finances and politics you can track thoroughly, like your local or state government, and investing in bonds backed by recession-proof, essential services, it’s possible to avoid potential blow-ups and ride out the current muni mess. It’s far from easy, says Matt Fabian, research director of Municipal Market Advisors, “but in some cases you can figure things out.”
Of course, doing due diligence on a bond issue isn’t the most entertaining way to spend a Saturday afternoon. Issuing documents are often hundreds of pages long, written in dense legalese. Bond issuers are slow to disclose bad news, and with about 1.5 million separate bonds out there, it’s a highly fragmented market, says Marilyn Cohen, head of Envision Capital, a Los Angeles fixed income investment firm. That’s why most people rely on their broker, or simply buy a muni bond fund. Still, not every broker is a muni expert and may not have access to bonds that meet your needs. Doing your own research is time consuming, says Gibb, but it gets easier with practice.
Before looking for new bonds, take an inventory of your current portfolio to see if your bonds and their issuers are as good as they were when you bought them. Many issues have lost the safeguard of municipal bond insurance, which backed high-quality ratings for about half of top-rated bonds before the 2008 crash, says George Rusnak, managing director at Wells Fargo Wealth Management. Now, he says, only about 7% of top-rated munis are insured – at a time when state and local governments are increasingly strapped for cash. “Quite frankly, we’re seeing a lot of people who don’t understand the credit problems they have” in their portfolios, Rusnak says. Be prepared to hang on to bonds that have lost value and simply cash out at maturity, he says.
Once you know what you’ve got, look at gaps in when your bonds mature. The goal is a ladder of bonds that are constantly maturing, with about a seven-year spread at minimum, Gibb suggests. Bear these fundamental ideas in mind when you go shopping:
Buy what you know or can learn
Purchase general obligation and essential services bonds for utilities and sewage service in areas where you have a solid understanding of economic conditions. “People are not doing away with their water or their electric bills, even if they’re not paying their mortgage,” says Gibb. And only 1% of munis in payment default come from such essential sectors, according to Municipal Market Advisors data.
Read the official disclosures
The Municipal Securities Rulemaking Board’s Electronic Municipal Market Access site, called EMMA, lets you check a bond’s original issuing statement, which explains its purpose and proposed source of repayment. The site also has price and yield data, trading history and important required disclosures. Check annual financial reports and other material information: Notices of late payments, draws on financial reserves, ratings downgrades and any changes to bondholders’ rights are typically cause for concern.
… but don’t stop there
The official disclosures have about a six-month lag, says Merritt chief executive Richard Ciccarone, so local media near the bond issuer may offer a more current perspective. Bookmark the web sites of newspapers that cover the areas in which your bonds were issued, or set up a Google News alert to help you stay on top of reports on regional unemployment rates and city and state budget woes. Bond analysts also check state fiscal watch lists for financially troubled cities, says Fabian.
Look for uncommon indicators
Less straightforward measures can help bondholders understand the ultimate health of a community. Gibb likes to use U-Haul (UHAL) rate comparisons as a barometer of local markets: If rates for a one-way move from Detroit to, say, Atlanta, are much higher than the other way around, it’s because Detroit is losing residents and not getting new arrivals, he says. And that affects property taxes, sales taxes and income taxes, the lifeblood of the steadiest municipal bonds. Similarly, a local mall closure, for example, will directly affect a sales-tax-backed bond, says Fabian.
Avoid high-yield one-offs
Bonds that support stadiums, cable fiber optic systems and new housing developments can be attractive because they often pay higher yields, but they depend on revenue that is particularly vulnerable to continued economic trouble, says Cohen of Envision Capital. Data from Municipal Market Advisors show that 94% of municipal bonds now in default are related to housing developments, stadiums, cable fiber optic systems, toll roads and other special projects whose financing collapsed in the economic crisis.
Municipal bond research – fundamentally, the decision whether to lend money to a local government – is based on common sense analysis of available public data, taken to a nearly obsessive degree, professionals say. There’s no surefire way to know when a state or local government might default or on which issues, but every state or local entity that issues a bond is required to file an issuing statement that explains how a bond gets paid back, plus annual financial reports and any notices of events that affect its credit quality. Governments and their budgets are also often covered by local media, which can offer some inkling of the financial tides. And even data from unlikely sources can be useful, which is why experts recommend buying muni bonds close to home, so it’s easier to keep track. The key is figuring out your bond issuers’ financial facts and knowing what’s truly relevant to your investments.
Next: 5 Risky Issues to Avoid
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