Muni bond jitters mean bargain prices for buyers

The idea of a boring, safe investment has never sounded so good after a year in which everything from stocks to real estate got flat-out clobbered.

Municipal bonds, among the blandest investments of all, could fit that category if you believe the experts who tout them as a bargain buy following a down but not horrible year.

"There could be more volatility in the year ahead, but if you have a longer-term horizon we think they are very good investments," said Miriam Sjoblom, a mutual fund analyst at Chicago-based Morningstar Inc.

Often called muni bonds or just munis, municipal bonds are issued by cities, counties, states and utility districts to raise money for roads, schools and other projects. The interest is typically free from federal income tax and also often exempt from state and local taxes if you buy one issued in the state where you live.

Returns are typically modest - these are bonds, after all. National intermediate-term muni-bond funds (average maturity between five and 12 years), had annualized average gains of 3.33 percent over the last 10 years despite losing 2.4 percent last year, according to Morningstar.

But the tax-free feature can make them an appealing option for conservative investors, especially those in higher tax brackets, compared with taxable corporate bonds. And the long-term outlook remains steady.

Here are six things investors should know about municipal bonds in this environment:

1. MUNIS STILL GENERALLY SAFE: While munis are not risk-free, they have maintained an excellent safety record. Experts say there's a very low risk of states or municipalities defaulting. "Even in this environment they're still one of the safest investments you can find in terms of non-payment," said Dick Larkin, director of research for Herbert J. Sims & Co., a financial services company in Southport, Conn.

2. HIGH YIELDS MAKE FOR BARGAIN BUYS: Yields on muni bonds - their expected rates of return - are at or near historical highs, reflecting the lengths to which issuers must go to attract risk-averse investors in a market made skittish by the credit crunch. That makes new purchases of munis a relative bargain. But it also means the prices on previously purchased bonds are declining, since the price reflects the lower yield on those bonds.

3. CURRENTLY PAY MORE THAN U.S. BONDS: Despite the low default rate, the market is so wary that tax-free muni yields have risen above the taxable yield on U.S. government securities with similar maturities, contrary to the historical trend. As of early January, 30-year Treasuries pay slightly more than 3 percent while tax-free yields for munis of similar maturities are about 5 percent.

A basic appeal of municipal bonds is their tax advantages. Most often their nominal yield is lower, but it can be close to the equivalent yield on a taxable bond. There are several bond yield calculators on the Internet that can help investors clarify the difference in the bottom-line returns between taxable and tax-free bonds.

At the moment, when taxes are factored in, the municipal bond investor gets more than double the after-tax return on Treasuries. Larkin calls this an "aberration" that won't last.

4. DOWNGRADES REFLECT INCREASED RISK: Major bond insurers, which were hurt by their role as guarantors of mortgage-related securities, have been downgraded by all of the major ratings agencies. The downgrades have roiled the market and underscore the need for investors to do their homework.

5. MANY UNRATED: Bonds rated by Standard & Poor's and other ratings agencies currently have strong credit quality; more than 98 percent of S&P's muni-bond ratings are in investment-grade categories, meaning a rating of BBB- or better. But many muni-bond issuers are unrated, especially smaller ones, and their bonds tend to be more vulnerable to default. About 85 percent of the approximately 1,300 munis that have defaulted since 1986 have occurred on unrated bonds, according to S&P.

Jeff Tjornehoj, a Denver-based senior research analyst with Lipper, foresees a significant number of defaults this year but says the vast majority will be very small municipalities whose bonds are not widely held. A muni bond fund's holdings could include unrated bonds - a fund's prospectus should make clear whether it takes a lot of risks and invests in unrated, below-investment-grade bonds.

6. BUYING FUNDS SAFEST OPTION: Investors can buy munis as individual bonds, mutual funds and exchange-traded funds. Those with the inclination to buy individual bonds can get pricing and basic buying information at such sites as Investinginbonds.com, which was created by The Securities Industry and Financial Markets Association to help educate investors. Of course, a diversified fund with hundreds of bonds won't be hit as hard in the event of a default or two.

---

On the Net:

http://www.investinginbonds.com