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Muni Bonds: Safe or a Sucker's Bet?

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Muni bonds are on death row. At least that's what you'll hear from The Wall Street Journal, TIME, The New York Times, and others. But not from Tom Kozlik, vice president and municipal credit analyst at Janney Montgomery Scott. Tom says pundits forecasting a municipal bond meltdown are wrong -- and he's done the analysis to back it up. If you've got munis on your radar or in your portfolio, you'll want to read James Early's interview with Tom below.

James Early: Warren Buffett says municipalities are in big financial trouble and that their bonds are headed for a "terrible problem" in five to 10 years -- a problem they'll resolve by defaulting and sticking their bond insurers with the bill -- as Harrisburg, Pa., nearly did to Ambac (NYSE: ABK  ) before the commonwealth stepped in. Yet you declare fears of a muni meltdown to be overblown. Why?

Tom Kozlik: Before I get to Buffett, let me address the skeptics predicting a near-term "municipal meltdown" in 2010 or 2011: It won't happen. Municipal bonds are not dot-com stocks or subprime loans. Muni bonds are generally still solid investments and will continue to pay principal and interest. Municipalities are becoming resourceful using new methods to create revenue streams while cutting fat from their budgets. Historically, municipal issuers have very low levels of default and an even lower level of bankruptcy. They don't want to jeopardize their access to the capital markets.

Also, it is important that investors understand that examples such as Harrisburg, Pa.; Central Falls, R.I.; and Buena Vista, Va., possess extenuating circumstances. They don't reflect the overall market. In fact, a recent Rockefeller Institute study reported that state tax revenues in 2Q 2010 saw a second consecutive month of positive growth compared to revenue from a year earlier. Although revenues are still not at pre-recession levels, this multiquarter recovery means that the worst is probably over.

As for Mr. Buffett's prediction, some governments' expenditures on health care and retirement benefits have been too high, and fewer government employees are paying into the plans as jobs are eliminated. But this has been an issue for years; it's just more visible because now state and local budgets are becoming so tight. Some of the aged municipalities which have been losing population could be up against a wall in the medium term if they don't rein in their spending. However, I do not see a "terrible problem" like Buffett anticipates.

Early: Can investors trust municipal bond rating agencies: Moody's (NYSE: MCO  ) , McGraw-Hill's (NYSE: MHP  ) , Standard & Poor's, and Fitch?

Kozlik: The rating agencies swung and missed on assessing the risk of and rating subprime mortgage loan structures. But their mistakes in that area do not mean that municipal ratings are worthless. In fact, we have found the rating agencies perform a very thorough analysis of the municipal credits they rate. There are occasionally situations in which issuers do not sell debt on a regular basis. Therefore, their ratings become somewhat stale if not re-evaluated. But the staffs at Moody's, S&P, and Fitch who cover municipal issuers have unparalleled experience and an exceptional amount of expertise in municipal market credit.

Early: Berkshire Hathaway (NYSE: BRK-B  ) got into the municipal bond insurance business in 2008. What's the current status of that market, and what does the future hold for municipal insurers?

Kozlik: About five years ago, over 50% of the municipal market's bond issues were insured by one of the 11 highly rated, mostly AAA, insurers. The percentage of insured new-issue municipal bonds is now closer to 5%. The reason is lack of supply. Although National Public Finance Guarantee Corp. (Baa1/A), formerly MBIA (NYSE: MBI  ) , is rated above investment grade, the company is currently not underwriting new municipal insurance policies. Berkshire (Aa1/AA+) has not underwritten a new municipal policy since 2009. The only company underwriting new municipal insurance policies is Assured Guaranty Corp. (NYSE: AGO  ) (Aa3/AAA) and subsidiary Assured Guaranty Municipal Corp. (Aa3/AAA), formerly FSA before Assured acquired it in 2009.

Early: Would the federal government bail municipalities out, and do their bond prices incorporate an implicit guarantee?

Kozlik: The federal government has already bailed states and municipalities out. Billions of dollars of budget relief and funds for other government programs went to states and municipalities in the American Recovery and Reinvestment Act of 2009. One notable program is the creation of the Build America Bond program. An Aug. 4, 2010, Treasury Department report stated, "Despite some of the recent headline risk and the challenging economic outlook ... the municipal market appears to be in reasonably good condition." The report ends by concluding, "Implicit in this analysis is the federal government's willingness to intervene in the event the municipal market ceases to function."

Early: Are the new Build America Bonds -- federally subsidized muni bonds created in 2009 as part of the American Recovery and Reinvestment Act -- good for taxpayers?

Kozlik: An August Congressional Budget Office study raised the cost estimates of the BAB program to $36 billion over 10 years. This is a somewhat controversial issue because BABs were created in 2009 to help the municipal market recover. They were created in order to attract investors who did not normally participate in traditional tax-exempt municipal sales. The new type of bond is set to expire at the end of 2010. It is expected that they will be renewed with a lower subsidy rate, but they have really achieved what they were set out to accomplish.

Early: Tax rates are going up. Have muni bond valuations risen to anticipate an influx of new buyers?

Kozlik: Aside from Treasury yields, which are very low now, municipal bond prices are affected by supply and demand. Although overall municipal issuance is on par to be on the same level or slightly higher than last year, 30% or more will end up as taxable Build America Bonds, which issuers have been able to sell at more affordable rates than tax-exempt bonds. This means less tax-exempt supply. Retail holdings of municipal bonds have steadily risen over the recent years, and the tax advantage will likely become more valuable as the Bush tax cuts roll off.

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True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

James Early owns no stocks mentioned in this article. Berkshire Hathaway and Moody's are Motley Fool Inside Value selections and Motley Fool Stock Advisor picks. Motley Fool Options has recommended writing covered calls on Moody's. The Fool owns shares of Berkshire Hathaway and has a disclosure policy.

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