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Who's Afraid of Municipal Bonds?

Simeon Hyman

For a brief moment the municipal-bond market appeared to be getting back to normal.

When Treasury yields first started to rise in early May, muni yields didn't rise in lockstep. In fact, the ratio of muni-bond yields to Treasury yields dropped to near the longer-term average of around 90 percent. That made sense, because investors are willing to accept lower yields on muni bonds in order to reap the tax benefits they carry.

The ratio of muni-bond yields to Treasury yields recently jumped back up to well over 100 percent and is still above its long-term average. That's an indication that something about munis was making investors nervous.

From mid-May to mid-June, the Barclays Aggregate Bond Index of taxable bonds has lost 1 percent, while the Barclays Muni Index has lost 2 percent. That might not sound like much, but we're talking about municipal bonds here, not stocks.

What happened? Three things: Detroit, Burlington and Rhode Island.

Detroit is moving toward a possible bankruptcy filing. No surprise there, you might say, considering the city's exposure to the auto-industry meltdown. But why would Burlington, Vt., a city of only about 42,000 people and no such exposure, be in trouble? It seems Burlington chose to install a fiber-optic cable network in the 1990s that turned out to be more expensive than planners thought. The project hasn't gone well, financially speaking, and the city's credit rating may be downgraded to junk. And now to Rhode Island, the smallest state in the U.S. by size. Some time back, the state guaranteed a pile of loans for a company owned by the well-known former Red Sox pitcher Curt Schilling. The business went bankrupt and now Rhode Island is debating whether it has the wherewithal to stand by its guarantee on $75 million of debt. If it doesn't, a downgrade is likely.

Are events like these the beginning of a municipal-bond crisis? Not likely.

Municipal bankruptcies remain rare, and for investors who pay taxes, these muni yields are quite attractive. But headline events like those above serve as a caution of sorts and a reminder that it doesn't take a municipal bankruptcy to adversely impact investors. Since the end of April, the spread - or additional yield - commanded by 20-year, BBB-rated munis over only modestly better-rated A-grade muni bonds widened by a quarter of 1 percent. That means that those BBB-rated bonds lost an additional 1 to 2 percent of their value relative to the A-rated munis.

So while it's unlikely that a municipal-bond crisis is in the offing, it's a timely reminder that not all municipal bonds are created equal and that credit quality and due diligence ultimately matter.

Simeon Hyman is Chief Investment Officer of BloombergBlack, a new offering available by invitation to affluent investors looking for a smart, easy way to take control of their personal wealth. For more information, visit BloombergBlack.

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