January 28 2008: 5:27 AM EST
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Why munis are a buy now

The turmoil in the credit markets doesn't involve tax-free bonds, but it's creating a tremendous buying opportunity for ordinary investors.

By Jon Birger, senior writer

(Fortune Magazine) -- Forget what you may have read in the newspaper about state budget problems or bond insurer meltdowns. This is a perfect time to be buying municipal bonds. The economy is slowing, the Federal Reserve is poised for more interest rate cuts (boosting bond prices), and a Democratic win in November would probably lead to higher taxes on the rich, thereby enhancing munis' tax advantages. Throw in munis' microscopic default rates, and you've got an ideal landing spot for investors weary of the stock market roller coaster.

Right now the yield on a 15-year, single-A, state of California bond is 4.5 percent, according to Bloomberg data. That's the equivalent of a 7.72 percent yield on a taxable investment for a California resident in the highest tax bracket. And before you start clucking at that single-A credit rating, ask yourself whether Warren Buffett would be getting into the bond insurance business - he launched Berkshire Hathaway Assurance Corp. in January - if it weren't a slam dunk. The historical default rate on single-A-rated munis is 0.0084 percent - 80 times lower, according to rating agency Moody's Investors Service, than the historical default rate on triple-A-rated corporate bonds.

Yet not only is there no stampede to buy munis, but the market is actually mired in its worst slump in nearly a decade. The 3.29 percent return of the Merrill Lynch municipal index in 2007 was less than half its annualized return over the past 19 years.

Before we try to make sense of this, here's a quick muni primer. Municipal bonds are sold by states and localities to help fund roads, schools, water systems and other government projects. Some of these bonds are backed by the full-taxing authority of the issuer and are known as general-obligation bonds, or GOs. Others are backed by revenue from specific tolls, taxes or fees; they're called revenue bonds. And a few of them are really corporate bonds masquerading as munis. (The munis funding a new stadium for the New York Mets are a prime example.)

To make it less costly for states and municipalities to borrow, the federal government exempts interest on muni bonds from federal income tax. Most states offer a similar exemption from state income tax, at least on munis issued in-state. Consequently there's strong demand from wealthy investors in high-tax states like California and New York for their own state's municipal bonds.

As we said, the default rate on munis is minuscule, especially for GOs, water-and-sewer revenue bonds, and the other plain-vanilla offerings that make up the majority of the muni market. Even triple-B-rated munis - the lowest rung of investment grade - have a default rate of only 0.06 percent. Nevertheless, the yield differential between bonds of different ratings - known as the credit spread - has always been considerably wider than seems justified given the default rates. For instance, the historical default rate on double-A munis is actually a tad higher than that of single-A's, yet the credit spread between the two is often a quarter of a percentage point.

Over the years, this incongruity has fueled the growth of Ambac (ABK), MBIA (MBI) and other bond insurance companies. By selling states and cities insurance that turns triple-B and single-A bond issues into triple-A's - reducing government borrowing costs in the process - the bond insurers manage to pocket much of the extra yield that would otherwise go to investors. Best of all, bond insurers rarely had to pay claims, certainly not on the plain-vanilla GOs and water-and-sewer bonds. "In my opinion," says Paul Disdier, who oversees the municipal bond fund division at Dreyfus, "the worst thing to happen to the muni market is the spread of bond insurance."

By 2000, the bond insurers were insuring half of all muni issues and began looking for new markets to conquer. Big mistake. One new market turned out to be collateralized debt obligations, which have morphed into a Wall Street deathtrap.

CDO-related losses have not only crushed Ambac and MBIA's stock prices, but they've obliterated muni investors' faith in the triple-A ratings of the municipal bonds these companies guarantee. Insured munis are now so out of favor, say analysts and bond fund managers, that some are trading at prices below that of uninsured bonds with comparable underlying ratings.

Perhaps because the market has been oversaturated with insured bonds for over a decade, investors have lost sight of the fact that the typical state or municipality - armed with multiple ways to raise revenue, often to taxpayers' chagrin - was always going to be a better risk than an insurance company. "It was preposterous to worry," Philip Fischer, Merrill Lynch's municipal bond strategist, says of fearful investors who've bailed on insured bonds in recent months. "New York City can send out gunmen to collect revenue. MBIA is just another corporation. Country clubs have more longevity than most corporations."

Municipal bonds have always been a disproportionately retail product, but panic-selling by institutional investors has been roiling the market most. Hedge funds - many of them betting wrongly that the gap between muni yields and yields on U.S. Treasury bonds would widen - were forced to cut their losses. Another problem, says a muni derivatives trader with a leading investment bank, has been the $100 billion in municipal bonds held by the big Wall Street firms. Already tagged with huge losses on their mortgage portfolios, banks have rushed to sell munis or hedge their exposure before the bond insurers lose their triple-A ratings.

(Able to raise capital to shore up their balance sheets, the leading bond insurers, Ambac and MBIA, have so far escaped rating downgrades. Two smaller ones - Security Capital Assurance and XL Capita - were not so lucky, downgraded from triple-A to triple-B and single-A respectively.)

The impact of all this Wall Street selling is most visible in the municipal credit default swap market, which allows institutional investors to buy and sell insurance against bond defaults. Without delving too deeply into the swap market minutia, suffice it to say that prices in the swap market have gone completely haywire and now assume a preposterous 30 percent chance of default for state of California GO bonds (rated single-A) and a 25 percent likelihood of default for New York City GOs (rated double-A). "These are stupid levels," says the trader. "Nobody is really worried about the underlying credits, yet people are scared to buy muni bonds."

Worried investors have been unloading insured munis by the bushel, paying little heed to the safety of the underlying credits. The bottom line: There's a terrific buying opportunity.

This is especially true for buy-and-hold investors - folks more concerned with income and preservation of principal than day-to-day fluctuations in the market value of their bonds. The ratio of muni yields to Treasury yields now exceeds 100 percent. A year ago it was 90 percent.

The easiest way to invest in munis is via mutual funds. Two good ones are Legg Mason Partners Managed Municipals (SHMMX) and Oppenheimer Rochester National Municipals (ORNAX), both of which carry a deferred load if you sell too soon. The Legg Mason fund is more conventional, Oppenheimer's more aggressive.

The problem with muni funds is that they eliminate one of munis' best attributes - guaranteed return of principal. With a bond, you know you'll get back your principal on a specific maturity date (or sooner if the bonds are called). With a fund, given the vagaries of interest rates, bond prices and net asset values, there's no way of knowing what price you will get when you decide to sell your shares.

If you choose to buy individual bonds, be aware that the muni market is not nearly as transparent as the stock market. Prices of existing bonds can vary widely from one broker to the next. One solution: Buy new munis when they are issued. You'll get the same price as the big investors, and newly issued bonds are sold commission-free (the broker's cut is built into the price). To top of page

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