Where the risk is (and isn't) in muni bonds

chart_ws_stock_vanguardintermediate-termtax-exemptfund.top.png By Annalyn Censky, staff reporter


NEW YORK (CNNMoney) -- State and local governments across the country are struggling under the weight of their budget woes.

But does that mean municipal bonds are no longer a safe-haven asset?

Even as finance superstars Meredith Whitney and Nouriel Roubini have sounded the alarms on munis, some investors are saying that's an overreaction.

"When we get a severely negative headline, the entire market reacts," said Guy LeBas, chief fixed income strategist with Janney Montgomery Scott. "But I would argue that the credit quality of government issues, remains, on average, extremely strong."

In December, Whitney made headlines with her controversial forecast of 50 to 100 major muni-bond defaults, totaling "hundreds of billions of dollars." And on Wednesday, Roubini's economic consulting firm predicted municipal bond defaults could total $100 billion over the next five years.

Since November, muni bond fears have run wild, driving up yields and pushing down their prices. But now, some investors are seeing an opportunity, despite the high-profile warnings, and it seems the muni market has calmed.

"It's kind of a Warren Buffett mentality," Lebas said. "Be greedy when others are fearful."

The argument is, municipal bonds -- which are tax exempt -- are now considered cheap and yielding more than ultra-safe Treasuries. The question is, with all the headlines about struggling state and local governments, have they become too risky?

Where the risk isn't

Rating agency Moody's is confident no state or major city will default on its debt this year. Even Federal Reserve Chairman Ben Bernanke has said muni-bond risks "have been looking somewhat better recently."

"Continued evidence that states and localities are addressing fiscal shortfalls should help calm the municipal bond market," Bernanke told the Citizens Budget Commission at a dinner Wednesday.

The risk of defaults is not at the state and or even city level, but at smaller, often unrated segments of the market, said Anne Van Praagh, Moody's chief credit officer for public finance.

She points to 2009, when there were 200 defaults in the market, but only one of those bonds had been officially rated.

"The process for local governments will be messy and noisy, but we think they're going to pay their debt for the most part," she said.

Of the roughly 11,500 government units it rates, Moody's has graded only about 50 cities below investment quality -- or junk status. Other than Detroit, which is the exception -- all the rest are small towns.

Where the risk is

In contrast, a vast majority of the muni bonds that have low ratings are for hospitals or housing projects.

"The muni market has always had two sides," LeBas said. "The traditionally stable issuers like state and local governments and utilities ... and the sort of ugly cousin, that's encompassed in small health care providers, senior living facilities, nonprofits and dirt bonds."

Bonds that fund land developments, often called "dirt bonds," are being strained by the still-struggling housing market, LeBas said. And bonds for small hospitals are increasingly risky, as they face both lower revenues and increasing operating costs related to health care reform.

LeBas recommends well-researched state and city debt, as well as toll roads and utilities as a safer bet.

"Even if economic times get tough, people still have to keep their water running," he said.

Broad-based bond funds may sometimes combine munis from both the safer and risky categories, so investors need to do their research or hire someone to do it for them, said Adrian Cronje, chief investment officer with Balentine.

They should also be mindful of the "headline risk" that makes municipal bonds volatile, considering headlines about a single analyst like Whitney can move the entire market, he said.

"I think the worst thing is to think, 'I have a need for safety, I'm going to buy cheap, low-cost passive municipal bonds,'" Cronje said. "People ought to consider a broader array of asset classes in the safe part of their portfolio today, including inflation-protected bonds and international bonds." To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.17%4.24%
15 yr fixed3.26%3.30%
5/1 ARM3.33%3.42%
30 yr refi4.16%4.22%
15 yr refi3.25%3.29%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 17,172.68 -107.06 -0.62%
Nasdaq 4,527.69 -52.10 -1.14%
S&P 500 1,994.29 -16.11 -0.80%
Treasuries 2.57 -0.02 -0.81%
Data as of 4:32am ET
Company Price Change % Change
Bank of America Corp... 17.03 0.08 0.47%
Yahoo! Inc 38.65 -2.28 -5.57%
Apple Inc 101.06 0.10 0.10%
EMC Corp 29.68 0.15 0.51%
Microsoft Corp 47.06 -0.46 -0.97%
Data as of Sep 22

Sections

Ferrari is recalling 3,000 of its exotic 458 sports cars because people get trapped inside the front storage compartment. More

UPS announced Monday that it's bringing its in-store 3-D printing service to nearly 100 stores across the country. More

Big pocketed borrowers are paying lower average rates on jumbo loans and lenders are now requiring down payments of just 10% -- and, in some cases, waiving the mortgage insurance, too. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.