Muni bonds: Set for worst quarter in a decade

By Blake Ellis, staff reporter

NEW YORK (CNNMoney) -- As investors fear cash-strapped states and cities across the country are on the brink of default and local governments slow debt issuance, the municipal bond market is heading for its worst quarter in a decade.

Only $44.4 billion worth of muni bonds have been issued in the first quarter of 2011. That's the lowest level since the first quarter of 2000, according to data from Thomson Reuters.

Part of the drop in issuance comes as budget shortfalls plague state and local economies -- leading to a freeze in demand from investors worried that the municipalities may not be able to get their books in order.

Another reason for the low level of issuance so far this year is that municipalities issued piles of debt at the end of 2010.

"There was a huge rush to issuance before the year end which limited the need to issue more debt this quarter," said Burt Mulford of Eagle Asset Management. "Some issuers knew they would get some taxes waived if they did it before the year end, and for planning purposes rates were relatively low so they rushed to issue that debt at these lower rates before the investing community became really nervous."

And now that the investing community is really nervous, demand and issuance have become further depressed.

In fact, California, the nation's top debt issuer, has announced that it may not issue debt this calendar year because of its budget crunch.

"There's a lot of pressure on state and local governments to not increase debt burdens, so they have ceilings on their net interest costs -- and if they've maxxed that out, they're not going issue more debt," said Mulford.

Time to hunt for bargains: But while this may be bad news for states like California, which risks not being able to finish government projects if it isn't able to raise money by issuing debt, this rock bottom market is a great buying opportunity for investors.

The rush out of muni bonds in the last few months has largely been an overreaction, said Mulford, adding that out of the $3 trillion muni bond market, only $8.9 billion muni bonds are defaulted. And of the $8.9 billion that are defaulted, 85% of them are non-rated issues, which are the riskiest of the asset classes.

So while Mulford recommends staying away from non-rated muni bonds, investment grade bonds are currently great bargains.

"Now is a great time to be buying munis because of their relative value and the fact that prices have been depressed over the last few months," he said. "Many investors have a rear view mirror mentality -- they look at asset classes from the previous year and buy one that is outperforming, so we've seen a reallocation from tax-free muni bonds into stocks just when you should be buying the underperforming asset class, which is munis."

But if you do decide to dip into the muni marketplace, Mulford recommends doing your homework about the economic situation of any municipality you're considering.

"You need to understand the revenue source of the municipality, look at pension obligations, and especially foreclosure rates, because the bonds are tied to property taxes -- so if there are a lot of foreclosures, taxes decrease and that will prevent the municipality for paying for services," he said.

That means if you want to buy California muni bonds, pick a city with a lower foreclosure rate like Palo Alto instead of San Bernardino.

In addition to foreclosure rates, the wealth of a city boosts a muni bond's safety. For example if you're looking at buying a New York muni, you should probably go with Westchester county over Buffalo, said Mulford.

"Typically if you buy munis from an area with a lot of wealth you're going to be safer than if you go into an area with a lot of poverty because the tax base is greater," he said. "You'll sacrifice some yield, but in this type of market we would rather sacrifice a little yield to protect our principal."

Because muni bonds are tax free, this is an especially good time to invest if you expect tax rates to go up in the near future.

"When tax rates go up, which I would say is likely in 2013, that's going to really raise demand for munis," he said. "So if you have any expectation that tax rates are going to go up, now is when you should be getting some munis."

And you better hurry up: Mulford expects this window of opportunity to close in the next few months.

"I think the economy has reached its low and is only going to get better and enhance the municipalities' ability to cover the costs of their services," said Mulford. "But the buying opportunity is probably only going to last a few more months -- as soon as issuance picks up, prices are going to go up." To top of page

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