Friday, January 21, 2011

States' finances are rotten, so what's a muni bond investor to do?

When you think of municipal bond investors, you typically think of quiet income investors whose biggest gripe might be having too many cards left over in canasta. You normally don't think of them as the type of people you have to tell to simmer down.

OK, you muni bond investors: Simmer down.

Mutual fund investors have yanked a net $24.8 billion from muni bond funds since Oct. 31, according to estimates by the Investment Company Institute, the funds' trade group. In contrast, investors have put about $8.5 billion into taxable bond funds during the same period.

Why are muni investors in a tizzy? The rotten state of the states.

Municipal bonds are long-term IOUs issued by states and municipal entities, such as airports, toll roads and state universities. When you buy a muni, you're a lender. And lenders like to get paid back.

Not too long ago, many muni investors could count on third-party municipal bond insurance to back their bonds. But the credit crisis crippled the muni insurance business. "Triple-A-rated insured bonds have all but disappeared," says Christine Todd, managing director of tax-sensitive fixed income at Standish Mellon Asset Management.

In recent months, investors have been wondering whether, in fact, the states will be able to live up to their obligations. Forty-six of the 50 states are facing budget shortfalls this year, says the Center on Budget and Policy Priorities.

And some of those shortfalls are doozies. Illinois' shortfall equals 40% of its 2011 budget; Nevada's is 54.5%. Part of the reason for the states' budget woes can be blamed on the recession: In hard times, states pay out more in unemployment benefits and take in less in taxes. Because this has been an unusually long and deep recession, many states have spent down any rainy-day funds they might have.

Another reason for big state budget woes, of course, is the unwillingness of politicians to match income with spending.

Faced with the prospect of financial catastrophe, however, many politicians have, in fact, started to address their states' problems in an adult manner. Illinois, for example, raised its state income tax to 5% from 3% - not long after rejecting an increase to 4.25%, says Todd. The tax increase alone is not enough to cure Illinois' ills, but it's a sign that politicians are willing to do what's necessary.

States have also cut spending. "They're facing tough decisions, no doubt about it," says Regina Shafer, portfolio manager at USAA.

Furthermore, many states are reducing long-term pension promises to new employees and cutting medical benefits. Those cuts have lasting long-term effects on state budgets.

And many states are seeing tax revenue rise as the economy starts its recovery, says Art Steinmetz, chief investment officer at OppenheimerFunds. U.S. Treasury receipts are up about 17% the past 12 months, he says, and state collections are likely to be rising at the same pace. What's more: Consumer spending is rising, which means that states can take in more from sales taxes.

But there's one other reason to look at muni bonds: yield. Income from municipal bonds is free from federal taxes. If you buy a bond from your state, interest is also free from state taxes.

Normally, munis yield about 15% less than comparable Treasury securities. The lower yields allow states to borrow at somewhat lower rates than the U.S. government or corporations.

Lower yields also mean that you often have to be in a high tax bracket to make a muni worthwhile. For example, suppose you're in the 33% tax bracket, and you're considering a muni that yields 3%.

To get the same return after taxes from a corporate bond, you'd need to earn 4.5%. So you'd turn down a similar, taxable bond that yields 4%. Someone in the 10% tax bracket, on the other hand, would be better off with the 4% taxable bond.

Currently, a top-rated 10-year muni bond yields 3.56%, vs. 3.43% for a 10-year T-note. You could be in the 0% tax bracket and munis would still be a better bet. Steinmetz says that some of his taxable bond funds are looking at munis now.

All bonds have risks, and Jeffrey Gundlach, star manager at DoubleLine, thinks yields might have to get higher - and prices lower - before the muni market turns around. But if you're a long-term income investor, it's time to simmer down and belly up to the muni bar.

By John Waggoner, USA TODAY

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