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.
- 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.
- 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.
- 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.