The Muni Maze Gets Tougher

Choose carefully to boost both safety and yield

Municipal bonds have had a strong run over the past 18 months, thanks first to the flight from the stock market and more recently to the Federal Reserve's aggressive interest-rate cuts. But now, muni yields, which fall when bond prices rise, are downright stingy, ranging from 2% to 5%. At the same time, many state and local governments are feeling pain from the slowdown. So is there any upside left?

Relative to U.S. Treasury bonds, munis are still attractive. The average 30-year top-rated municipal bond yields 4.96%, compared with 5.26% for 30-year Treasuries. But since muni-bond interest is exempt from federal taxes, if you're in the 30.5% tax bracket, that 4.96% is the equivalent of earning 7.14% in a taxable bond. Yields on short-term munis are low but also compare well. A 2.36% average yield on two-year munis is worth 3.4% after taxes for the 30.5% bracket. Two-year Treasury notes yield only 2.61%.

Yet finding extra yield these days takes some imagination. Now may be a good time to consider callable bonds, for instance. Investors typically shun them when rates are falling, since issuers can force their redemption in order to sell new bonds at lower rates. But with rates at their lowest in nearly four decades, bond experts think yields can't fall much further. So why buy noncallable bonds, especially since their yields are lower than callables?

That's why Marilyn Cohen of Envision Capital Management, a Los Angeles bond adviser, is buying older callable munis, such as Philadelphia Water & Wastewater, which has its first call in 2003. Because the bond was issued in 1993, when rates were higher, it yields 4%. "There's a huge probability it will be called," says Cohen. But so what? Noncallable munis of the same credit quality maturing in 2003 are currently yielding only 2.36% on average, so all costs considered, the callable 4% bond comes out ahead.

The sweet spot in the muni market is smack in the middle--the 7-to-15-year maturity range. That's because short-term yields are too low to be attractive, while long-term bonds can be risky if rates start to climb. "Buying a 10-year municipal bond right now will give you a significant percentage of the 30-year bond's yield with only a third of its interest-rate volatility," says Joseph Deane, portfolio manager for Smith Barney Managed Municipals Fund. Indeed, the average 10-year muni yields 4.01%, and a 15-year, 4.59%, compared with the 30-year's 4.96%. "It's not worth taking on the extra risk for less than half a percentage point of yield," adds Cohen.

The sorry state of the economy is changing conventional wisdom in the muni market, too. Usually, general obligation (G.O.) bonds, which are funded by pooled tax revenues collected by an entire state or municipality, are considered safer than revenue bonds, which are supported by the revenues from an individual project, such as a toll bridge or hospital. The fear is that if the project fails, its revenue bond will be in jeopardy.

BEYOND BASICS. Yet entire state budgets are in trouble now. "G.O.'s issued in North Carolina and Georgia, which depend heavily on sales-tax revenues, are vulnerable to the economic slowdown," says manager Christian Swantek of Armada National Tax-Exempt Fund. Also, states that rely on tourists to fill their tax coffers, such as Florida, Nevada, and Hawaii, are suffering from a terrorism-driven slowdown. California must recover a $12.5 billion shortfall caused by the bailout of bankrupt electrical utilities. And New York is reeling from the Wall Street bear market and the aftermath of the September 11 attacks. G.O. bonds issued in these states aren't likely to go into default, but they could fall in price.

For this reason, many pros are investing heavily in "essential-service" revenue bonds. "Electric power, water, sewer facilities--people are going to pay for these services regardless of the economic situation," says Thomas Spalding, portfolio manager for Nuveen Intermediate Duration Municipal Bond Fund. That's why Spalding invested in bonds issued by Utah's Intermountain Power Supply. (In California, the electric utilities that went bust were private companies that were suffering from skyrocketing power costs and a botched deregulation plan. California's public utilities are fine.)

Of course, not every G.O. is a suspect bond. A lot depends on how long you plan to hold it. Mutual funds are especially sensitive to changes in credit quality because their portfolios are priced every day, so they may need to sell a bond long before maturity. Individuals, on the other hand, tend to buy and hold muni bonds until maturity. In that light, G.O.'s are still a good bet. Their long-term default rate is less than 1%. They also may be less likely to be affected by terrorist attacks than, say, a specific power plant.

If you're buying individual bonds, you're better off with high-quality issues, rated from A to AAA, Standard & Poor's highest rating, or A to Aaa at Moody's Investors Service. "I would not recommend individual investors buy low-rated bonds," says Steven Permut, portfolio manager for American Century High Yield Municipal Bond. "They require a lot of credit research." That's especially true in this economic environment. It also helps if the bond is insured by a highly rated insurer, such as Ambac Financial Group or MBIA. That means even if the issuer is in trouble, the bond's interest and principal is guaranteed.

COMPARISON SHOP. Investors can get some good information on the Web (table). Start with, the Bond Market Assn.'s site. It provides a good listing of actively traded munis and has a price range for each issue it tracks. The range is significant because muni brokers typically include commissions in the prices they ask for the bonds. So it's difficult to tell whether you're getting a good price on an issue without seeing the range--the daily highs and lows of the prices at which the bonds traded.

Two of the better online bond brokers are and They're straightforward about their commissions. CSFBdirect charges $3 for each $1,000 bond, MuniDirect from $2.50 to $5, depending on the maturity of the bond (longer-term bonds have higher commissions). Both sites offer a bond screener that lets you search for munis by state, credit rating, maturity, and callability. MuniDirect also lets you search by muni sector and differentiate between revenue and G.O. bonds.

If all of this sounds like too much work for a 4% or 5% yield, you can buy a muni mutual fund. Just make sure the expenses are less than 0.5 percentage points. With yields so meager, you can't afford to have a fund company eating too much of your return.

By Lewis Braham

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