For the most part, municipal bonds have been a haven during the recession. But with many state and local governments facing dire budget problems, it’s time to ask how much more nasty economic news the tax-free market can handle. California, one of 48 states whose budgets are in the red, is so broke that it is issuing IOUs instead of checks for tax refunds and other obligations.
Eventually, the economy will be in better shape, which will mean lower unemployment and higher tax revenues. But until then, the muni market will remain soft. Since May, when doubts about a quick recovery set in, tax-exempts have lagged Treasury and high-grade corporate bonds of similar maturities.
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No states, and few municipalities, have actually missed interest payments. And it’s not a matter of investors reacting to downgrades by rating agencies. Serious bond investors today mainly read the headlines and issuers’ financial statements and then judge bonds accordingly. That makes yields and prices (which move inversely to one another) more subjective and less predictable.
Look at the action in a California state general-obligation bond maturing in 2034 and bearing a 5 percent interest coupon. If you own this bond and hold to maturity, you will almost certainly get what you’re due. When it comes to meeting obligations, California’s constitution puts only paying for education ahead of repaying bond debt.
But it’s another story if you have to sell before maturity. In the summer of 2008, California’s fiscal troubles were evident, but sellers of this bond still got 97 cents to $1.02 per dollar of face value. By mid-July 2009, sellers got only 83 cents to 85 cents, giving the bond a yield of 6.3 percent. And such wild fluctuations aren’t confined to California debt.
One reason muni-bond prices have been weak is that many potential buyers are holding out for higher yields, using worries about state and local revenues as their excuse. Demand is especially soft from hedge funds and other financial institutions, says Bill Walsh, a partner at Hennion & Walsh, a Parsippany, N.J., money manager and muni-bond dealer.
So the trend is for higher yields and lower prices until institutions start buying in large numbers. Barnet Sherman of Braintree Capital Partners, a money manager in Braintree, Mass., says that although California has seen dozens of financial crises, it’s hard to go wrong buying a California general-obligation bond or a local water-authority bond for less than 90 cents on the dollar; if you find one for 80 cents, it’s a steal. But until the muni market calms down, don’t mess with low-quality municipals from California — or anywhere else.
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