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5 Reasons Not to Panic Over California Bankruptcies

Richard Satran

Don't look now but there really has been an unusual string of bankruptcies in the muni market.

Is this the tsunami that analyst Meredith Whitney forecast more than a year ago? Investors pulled billions from munis in late 2010 and early 2011 after she predicted that hundreds of billions of dollars in municipal bonds would default.

Three California cities, two of them with populations of about 200,000, have opted for Chapter 9 bankruptcy filings in recent weeks, and other cities across the country like Scranton, Penn., are using emergency measures to avoid a filing.

The quick series of defaults in California surprised some people, and revved up the old worries that cities and towns are in big trouble. Experts remain unconvinced.

"It's really not widespread," says Peter Hayes, head of BlackRock's municipal bonds group. "These are not one-off things, but they are isolated."

[Watch California municipal bonds with these funds.]

To be sure, he said, many local governments are having difficulty funding basic services, and getting less help from state and federal sources.

Blame the Great Recession for the country's fiscal problems. For local governments, the problem is more directly linked to housing collapse. Property taxes fund over two-thirds of the cost of local government and education, and shrinking revenues are just now starting to have an impact. "It does not happen automatically," says Hayes. "There is a cycle to it."

Investors, however, are showing no concern. Lipper reports that there have been inflows every week this year to municipal bond funds, with nearly $1 billion added in the latest week. Is this yet another sign of a market unhinged? Is it time to panic? No, but it could be time to tread more cautiously. Here are alternatives for getting past the crisis without a panic, and perhaps adding some bargain munis to your portfolio:

1. Focus on investment choices that you can control. The economy and housing prices will follow their course. You cannot change that. "People have to be selective when they buy. These (municipals and state bonds) used to be thought of as commodities, all alike and all safe. But that's just not true," says Gabriel Petek, a state credit analyst for Standard & Poor's. The old assurance that munis never default simply does not hold anymore--in fact it never did. The Municipal Markets Advisors reports some $6 billion in bond defaults last year in the nearly $4 trillion market.

Risky ventures and overspending caused some failures. If you manage your own money, you might want to avoid the more esoteric corners of the muni market. A double-digit yield on, say, a new bond based on tobacco lawsuit revenue, might seem appealing, but the risks--for example, a drop in the cigarette sales that support the bond--could be a larger worry. Or, if your town is overloaded with cavernous shopping malls, investing in parking-lot bonds for the new megaplex could be a star-crossed venture.

2. Ignore the rhetoric of political budget battles. With municipal budget battles raging all over the country, cities are threatening bankruptcy as a way to curb unions and pull back on costly pension commitments.

But as cities and towns see cash resources drain away, the last thing they want to do is cut off credit lines. They are slashing salaries, pensions, and services first--not bond payments.

"People should be careful about reacting to all of the headlines," says Hayes. "These situations are complex." Each of them requires research, and Hayes touts the work of his own muni team at ferreting out the good from the bad, an important exercise when there is such diversity in the offerings. Many financial advisers say diversified funds are the best way for most people to invest in munis.

[See Top-Rated Municipal Bond Funds.]

3. Remember that California's fault lines do not run from West to East. In fact, in economic and political terms, the state really is an island (in addition to sitting on a tectonic plate that drifted in from the Pacific.) The bankruptcy-hit towns of San Bernadino, Stockton, and Mammoth are relatively affluent. But their real estate values plummeted and none can boost taxes enough to pay the bills.

Here's why: California is different from other states, since it froze the property tax increases under Proposition 13 in 1978. Since then, the state's property tax cap is a political sacred cow. State politicians in both parties are loathe to raise the state's property tax.

Still, the California economy is starting to improve, and real estate is steadying. That could help in the long term, but there will likely be more bankruptcies in the state before economic recovery comes to the state's rescue.

4. Muni prices may fall--but they are too high anyway. Through all of the credit upheavals of recent history, muni prices have behaved much like the debt issued by Uncle Sam. Their prices are at all-time highs, with yields at all-time lows. Summer is when the largest number of municipal bonds mature and municipalities need to issue more debt. The flood of new issues could put more supply in the market--and yields might have to rise to attract investors.

"June and July are slow (for investors)," says Petek. While many issuers will be bringing offers to market, buyers may be off at the beach. "You may see some elevation in yields."

Advisers say it might not be a bad idea to hold off muni buying until September.

5. Over the long haul, more people will want tax-free and fixed income. Munis are no longer the domain of the wealthy. The market will be boosted over time as demand from investors continues to grow. As Boomers start to tap the trillions they have in IRAs and 401(k)s, they will buy munis for their steady income and to avoid giving up too much for taxes. In addition, the expectation is that the Bush tax breaks will disappear and taxes will rise for upper-income people, creating still more demand for tax-free income. Some retirees are starting to worry about Medicare income caps as well, and munis help reduce taxable income.

But in the search for yield, don't get greedy.

[See Preparing for a Bond Bubble: 6 Investing Tips.]

Munis are considered a "can't miss" investment if a tax-free yield rises above Treasuries, which is the case now. The long-term yield for munis at 3.5 percent is slightly better than the Treasury yield. The tax-free yield equivalent is a full percentage point higher. But conventional wisdom may not hold, especially if the squeeze on local governments becomes too much for more and more municipalities to bear. The oracle of Omaha, Warren Buffett, said in a recent Bloomberg television interview that it appears municipalities are more willing to take the bankruptcy option.

That could boost bankruptcy filings, he said. But this will not augur the disaster some have forecast. "I don't think we're at the precipice," Buffett said.

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