Muni death watch concerns advisers

Many financial advisers consider municipal bonds to be relatively safe investments, but that image took a hit last week when Jefferson County, Ala., moved a step closer to what could be the largest municipal bond default in U.S. history. Rather than make munis less attractive, however, it could make them more attractive to investors looking for a bargain, several industry experts said. Jefferson County officials last week began preparing for a possible bankruptcy filing if an agreement can't be reached allowing the county to get out from under $3.2 billion of bonds issued to upgrade its sewage system — bonds that carry variable interest rates that have soared this year. In a last ditch effort to avoid a bankruptcy, Alabama officials Friday proposed restructuring the county's bonds at "lower, fixed interest rates over a longer term," The Birmingham News reported. It is anticipated the county's creditors will respond to the proposal this week, and delay any legal action for 30 days.
If the county files for bankruptcy, it would be the largest municipal bond default in U.S. history, bigger than the $2.25 billion default by the Washington Public Power Supply System in 1983 on revenue bonds it sold for nuclear plants in that state. Despite its size, the marketwide implications of a default by Jefferson County are unclear. If that occurred, the county's bond insurers would have to assume the interest and principal payments on the bonds. Eventually, the county would be required to reimburse the insurers. Other massive defaults are unlikely, industry experts said. Jefferson County's use of variable-rate notes and hedging techniques are "unique and not replicated in the vast majority of other municipalities," according to a Feb. 27 statement from Moody's Investors Service of New York. It is an unusual state of affairs, agrees Robert B. MacIntosh, vice president and co-director of municipal investments at Eaton Vance Corp. of Boston. "This is an isolated, rogue situation," he said. "Some government officials did some incredibly stupid things." But while they may not be in the exact same situation as Jefferson County, other muni issuers are under increasing fiscal pressure, said Matthew Dalton, chief executive of Belle Haven Investments LP in White Plains, N.Y., a broker-dealer and registered investment adviser with about $300 million under management. A sour economy and housing crisis have resulted in reduced tax revenue for municipalities and muni authorities, he said. Muni issuers in California and Florida are of particular concern, Mr. Dalton said. In these cases, real estate values have declined, and there may not be sufficient tax revenue to support bonds, he said. As a result, a "second wave of fear" is likely to wash over the muni market, Mr. Dalton said. The market was just beginning to recover from the first wave, triggered by rating downgrades in February of such muni bond insurers as MBIA Inc. of Armonk, N.Y., and Ambac Financial Group Inc. of New York. Those downgrades initially resulted in institutions' not being permitted to own debt below a certain rating, which caused a sell-off of munis and flooded the market. Muni prices dropped, and yields increased. Muni bond investors took a beating. But it created an unusual buying opportunity, said Bill Keller, a Washington-based senior vice president and director of investments for PNC Wealth Management, a member of The PNC Financial Services Group Inc. of Pittsburgh. The yield ratio of munis to their taxable equivalents is usually about 75%, he said. But when the monoline insurers were downgraded in February, the ratio spiked to about 135%, meaning that the yields on munis had increased dramatically, Mr. Keller said. He said that in-vestors were actually getting paid more yield for owning tax-free munis than comparable Treasuries — a very unusual occurrence. Eventually, the market appeared to realize that munis were undervalued. Prices rose, and the yield ratio of munis to their taxable equivalents fell to about 90%, Mr. Keller said. That has resulted in solid total returns for mutual funds investing in muni bonds — particularly funds investing in short- and intermediate-term bonds. Still, because of inflation concerns, funds investing in long-term muni bonds from across the United States are in negative territory. The category was down 0.07% year-to-date as of Aug. 27, according to Morningstar Inc. of Chicago. But for the same period, funds investing in short-term munis nationally were up an average of 2.04%, and funds investing in intermediate-term bonds nationally were up an average of 1.49%, according to Morningstar. That isn't bad, considering that the Standard & Poor's 500 stock index, meanwhile, was down 11.49%. Thanks in part to Jefferson County, however, the strong showing by munis may be short-lived. Muni bond prices could once again go down, and yields could go up, Mr. Keller said. Jefferson County, however, is so unique that it seems unlikely that it will have much of an effect on the entire muni market, said Ashton P. Goodfield, managing director and head of municipal bond trading at DWS Investments, a unit of Deutsche Asset Management Inc. of New York. "I'm not worried about that," she said. The muni market is very volatile, but does appear to be on an upward trend, Ms. Goodfield said. Help might be on the way. Having come under pressure to revaluate their ratings of muni issues, ratings agencies seem set to an-nounce potentially hundreds of upgrades, Ms. Goodfield said. After the ratings are recalibrated, the percentage of general-obligation bonds in the double-A and triple-A categories is expected to rise to 86%, from 58%, Fitch Ratings Ltd. of New York, a unit of Fimalac SA of Paris, said at the end of July in a draft proposal of its new ratings scale. It is all a little confusing, said Patrick Hanratty, a managing director with Capital Advisors Ltd., a Shaker Heights, Ohio-based firm with $550 million under management. Such confusion is why he said he currently favors investing in muni bond funds. Mr. Hanratty prefers holding individual bonds, but markets must first "normalize," he said. E-mail David Hoffman at dhoffman@investmentnews.com.