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Can You Profit From Muni Bond Turmoil?

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Municipal bonds don't often make financial headlines. And by "don't often" I really mean "never." They're about as exciting to talk about as the finer points of fertilizer formulations.

But the market's been a-quakin' and it's actually a very big deal, particularly for individual investors. Why? Because individuals are much more likely to own munis because of their tax advantaged status -- if not in the form of individual bonds, then through funds from companies such as Vanguard, Franklin Resources (NYSE: BEN  ) , or Nuveen Asset Management. Even investors that are largely in equities may have exposure through insurance companies such as Allstate (NYSE: ALL  ) and Progressive (NYSE: PGR  ) , which are invested in munis, as well as MBIA (NYSE: MBI  ) and Radian Group (NYSE: RDN  ) , which are on the muni hook through insurance contracts.

Of course, the more important reason we may care about the turbulence in the muni market is that fear in a market can lead to profitable opportunities for alert investors.

Why do you hate America, Meredith?
How exactly did we get here in the first place? There's been a lot of focus on Meredith Whitney's call for 50 to 100 major muni defaults this year as the cause of the unrest in the muni market. And it's probably true that her bold proclamation did shake things up.

But I don't really care what Meredith Whitney has to say. Thus far, she's had one great call on Citigroup and that's about it. I'm not saying she won't prove to be a font of foresight in the financial markets, but I'd like to see her get a few more prescient predictions under her belt before I start hanging onto her every word.

That said, there are good reasons to be concerned about munis (and Whitney was far from the first to note this). City and state revenues have been under pressure from the recession and pension benefits, and many states face hefty budget shortfalls -- among the more well-known are California and Illinois with respective $25 billion and $15 billion gaps.

But there have been other factors at work, too. The Build America bond program expired at the beginning of the year, and that helped put pressure on the market at the end of last year. The extension of the Bush-era tax cuts kept taxes low on certain types of investment income, reducing the need to seek tax protection through munis. And, of course, the same inflation worries that have investors concerned about other fixed-income investments pertain to munis as well.

Is it really that bad?
I'm not convinced by the bears though. If things had gotten out of control, we might expect to see a huge jump in issuance as borrowers went wild. In fact, muni issuance has grown by about 6% per year from 1996 to 2009. That's a decent clip, but I'm not sure it suggests wild irrationality.

Compare that to the mortgage market where residential mortgage originations grew 13% per year from 1993 to 2003 and ballooned a total of 270% in the three years from 2000 to 2003.

Additionally, the financial condition of many municipalities is already starting to improve as the economy inches back to life. If the economy can continue to trudge in the right direction, revenue will increase and give municipal debtors more breathing room.

The amount of debt that states are carrying isn't particularly crazy either. The U.S. has debt equal to about 60% of gross domestic product. California's debt is 4.7% of GDP, Illinois' is 3.8%, and Texas' is 1.1%.

To be sure, I'd hardly say everything is hunky-dory. In fact, one of the key things that worries me about the muni market is the refrain from muni supporters that these bonds historically have an exceedingly low default rate. While that may be true, it's when investors get too complacent about the safety of an asset class -- remember "housing prices never go down"? -- that trouble is often brewing.

Finding value in munis
I'm still at the beginning of my dive into munis, but weighing the overall market's yield against the real problems that exist, I'm not sure I'd call it a pound-the-table bargain. There may be some individual bonds that are already significantly mispriced, but I figure that something more concrete, like even an insignificant default, could shake the market enough to create more enticing values. In anticipation of that possibility though, being in waiting mode gives me the opportunity to dig into the market further so that I'm ready if another wave of panic comes along.

The easiest way to get, or increase, your exposure to munis is to do it through a high-quality muni fund. But I know many Foolish readers are like me and like to get their hands dirty and find opportunities for themselves. If you fit that description, here are three points to help you start investigating the muni market.

  1. Do your diligence. Just as with stocks, it's imperative that you know what you're investing in -- and that doesn't mean simply knowing the yield and the maturity of a bond. The Municipal Securities Rulemaking Board's website has documents on a lot of muni bonds, but, generally speaking, information is tougher to come by in the muni market so in a lot of cases you're going to have to work a bit harder.
  2. Know your bond. Just as there are many types of companies with many types of business models, there are many different flavors of bonds. Some are general obligations of the municipality and paid for with tax revenue, others are paid through revenue generated by the project that the debt paid for, still others have twists that might combine the two. If you don't understand where the money will come from to pay your interest and principal, then you're going to have a tough time figuring out if you'll get stiffed.
  3. Who's behind your bond? In some cases muni bonds have a safety net. As noted above, bond insurers are on the hook if defaults fire up, but assuming the insurers can stay on solid footing, they do provide protection, so it's worth figuring out whether a given bond has insurance. Other bonds have a distinctly corporate flavor. Industrial development revenue bonds, for example, are bonds backed by corporations such as Dow Chemical (NYSE: DOW  ) and International Paper (NYSE: IP  ) but issued through the muni market.

Any muni bond sharks out there who want to build on this list? Have some questions not answered here? Head down to the comments section below and weigh in.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (5) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 23, 2011, at 3:02 PM, BlueHavenCapital wrote:

    I would add this point #4 to the list and then move it up to number one:

    Buy escrowed and pre-refunded munis. The market in tax exempt ETM and pre-re paper is still only 25 to 30 basis points richer in the 10 year sector than a AA rated muni, so why not buy the pre re? Up until a few weeks ago, the munis were trading CHEAPER than Treasuries...on an absolute yield basis, not a tax exempt equivalency basis.

    The panic stricken rush to exit the muni market has left some stellar credits trading at some unbelievably cheap relationships to Treasuries and that won't last forever.

  • Report this Comment On February 23, 2011, at 8:02 PM, ynotc wrote:

    If the Muni market is the shape that you say that it is then why the discussions about allowing states and municipalities to declare bankruptcy?

    I think that the situation in Wisconson is a microcasm of what will need to play out in other states and municipalities. Either the unions make substatial concessions or the entities will need to decalare bankruptcy to remove the impossible, unsustainable, unfunded liabilities as GM and Chrysler did.

  • Report this Comment On February 23, 2011, at 9:07 PM, newageinvestor wrote:

    @ynotc. According to an article on the front page of the Roosevelt Institute website, graphing state budget shortfalls against union density and against a variable they call negative equity relative to mortgages, reveals that housing bubbles are the predictor of state budget shortfalls, not unions.

    If we're going to make arguments here, lets keep them data-based, not emotions based. Same holds true for stock picks.

  • Report this Comment On February 24, 2011, at 2:17 PM, ynotc wrote:

    newageinvestor, in science in order to show a correlation you must isolate the variables. Since we are unable to do this to any reasonable degree I find that your "correlation is strictly annecdotal as you you have defined mine.

    Public sector unions are parasitic in that, generally speaking, the members make more on the average then the population that is being taxed to cover thier wages. This becomes a problem organically speaking when the parsites begin to outnumber the host and therefore becomes unsustainable. We are reaching that point if we have not already surpassed it.

  • Report this Comment On February 24, 2011, at 5:09 PM, Millsteen wrote:

    The "panic" has created opportunities for investors since the market is repricing everything lower whether it's triple AAA or garbage. I have found terrific bargains for great municipalities. While I don't think it's ever healthy for one analyst like a Meredith Whitney to have the power to create a panic in a market, if you're an investor you should thank Meredith. With that said, prices are starting to creep up again since the initial market reaction always overshoots the mark whether it's good or bad. Again, stick with AA or better and pre-refunded is money in the bank.

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