Wednesday, December 19, 2007

The Muni Bond dilemma

Many investors include Municipal Bonds as a portion of their portfolio. Muni Bonds have the advantage of being federal and state tax-free while normally delivering solid yields. The overall returns from Muni Bonds crushed Treasury and corporate debt sectors from 2004 to 2006. This year is shaping up to be a different story.

The MBH3 Muni Index and others are trailing the debt market in 2007 as the recent subprime credit crunch raises concerns about agency rating of this debt as well as the ability of bond insurance companies to guarantee the Muni Bonds after all the mortgage derivative losses.

Other headwinds facing Muni Bonds include the pension payment crisis unfolding in many states and communities. Governments have under-funded their pension funds for many years and now the vultures are coming home to roost. Many entities will have difficulty funded current operations and paying retirees. This is coupled with that many local governments have invested their funds in derivative debt pushed by Wall Street and have suffered staggering losses (see Will State SIV Funds bankrupt local communities?). There is also the expectation that reduced consumer confidence will lead to falling revenue for projects financed by communities such as stadiums, museums, and theaters. This is all occurring at a time when many localities are observing faltering tax collections due to foreclosures.

At this point, institutions and hedge funds are not stepping up to purchase Muni Bonds. Hedge fund losses for the year in Muni Bonds have ranged from 5 to 30 percent. The lack of buyers is likely to lead to further losses. This has also caused recent issues offered by state and local governments to pay much higher interest rates in the market.

Even with the recent turmoil, investors should for the most part hold any current Muni-Bonds or Funds in their portfolio for the long term but not make additional purchases. However all bond holders should investigate the principal and interest risk for any individual Muni Bonds in their brokerage accounts and sell those that appear to be at high risk of downgrade or default.

Muni Bonds Swoon With Worst Total Returns Since 1999

“The funds are seeking new accounts, but their recent performance was a lot worse than some people thought possible,'' Ratnow said. ``On the positive side, the funds have a history of producing big gains after months with big losses.''