So You Think Munis Are Safe?

The 1990s saw a rash of flawed high-yield bond projects. Now, that bubble is bursting all over the U.S.

When city officials set out five years ago to give Denver's downtown a lift, a "world-class" aquarium looked like just the ticket. Ocean Journey would lure 1.2 million free-spending visitors a year. The best part: It wouldn't cost taxpayers much. Helped by its cachet as a safe municipal issuer, the city raised nearly $60 million from investors by selling high-yield bonds that paid solely from the box office.

Alas, for investors, low out-of-town traffic, static exhibits, and high ticket prices meant the aquarium got two-thirds of the visitors it expected. In April, Ocean Journey filed for bankruptcy after city officials declined to bail it out. "We decided it was in the best interest of the city for the aquarium to proceed on its own," says Bob Gibson, Denver's director for financial management. Now, bondholders, including the Delaware Investments and Putnam Investments mutual-fund complexes, are holding a soggy bag. A restructuring may avert a shutdown, but at best, they'll get a fraction of expected returns.

Across the U.S., investors are getting similar shocks. During the boom, a record $150 billion in high-yield municipal bonds financed a building spree--aquariums, stadiums, toll roads, amusement parks, and housing projects. Unlike bonds backed by state or local taxes, they had no claim on public coffers. Yet investors disregarded the risks because of tax breaks associated with muni bonds and the perception that government issuers don't default.

Now, this high-yield muni bubble is bursting as the weak economy reveals the projects' flaws. A few cities have made revenue bondholders whole in the past--Tampa bailed out its struggling aquarium in 1996. But most say they can't support such projects now. In June, several Alabama communities let VisionLand, a three-year-old amusement park financed by $90 million in revenue bonds, file for bankruptcy.

The biggest problems are toll roads. Of the 10 major ones constructed since the mid-1990s, nearly half carry far less traffic than projected. Some $4 billion in toll-road bonds risk default over the next five years unless they're refinanced, estimates Robert H. Muller, a municipal bond analyst at J.P. Morgan Securities Inc. Among the problem roads is the $200 million, 16-mile Southern Connector in Greenville, S.C. Designed to steer traffic toward some private developers' planned projects, the road opened just as the recession hit in February, 2001. Drivers detour to avoid the $1.50 toll, so less than half the projected 28,000 commuters use it daily. Some blame consultants hired to assess the projects. "There is a history of feasibility studies for toll roads being overly optimistic," says John J. Hallacy III, director of municipal bond research for Merrill Lynch & Co. Greenville officials say the local economy will eventually generate the traffic. But Richard Few Sr., chairman of Connector 2000 Assn., which oversaw the road's financing and construction, concedes that investors wouldn't get much in a default. Control of the road would revert to the state--not the bondholders.

Statistics are scarce, but Wall Street pros estimate that defaults of high-yield munis--which are largely bought by mutual funds--jumped this year from 2% to 3% and are heading up. That sounds small, but it's nearly 10 times the historic 0.3% default rate for mainstream munis backed by taxes. "There are going to be some grenades, some definite hits to value that make you wonder what they were smoking when they bought this," says Jeffrey M. Wilson, co-manager of Saybrook Capital LLC's Saybrook Tax-Exempt Opportunity Fund, who buys distressed muni bonds, betting on a restructuring.

While investors' losses in risky public projects may seem a pinprick compared with the trillions wiped off the value of stocks, the high-yield bond blowup bears close watching. The riskiest bonds may be the canary in the coal mine for the $1.6 trillion municipal bond market. The nation's state governments' collective operating deficit will likely come in at nearly $50 billion in the fiscal year ended June 30, 2002, vs. a $23.9 billion surplus in fiscal 2001. California faces a staggering $25 billion deficit in its 2002-2003 budget. This year, Standard & Poor's has downgraded New Jersey, Wisconsin, and Colorado debt, and put four other states on negative outlook. "We think it's going to be a pretty difficult environment for the states," says Robin L. Prunty, a director at S&P's public finance ratings department. "I see very little upside."

Unfortunately, small investors don't see it that way. Panicked by their stock losses, they're blindly pouring money into the perceived safe haven of muni bonds. A record $320 billion is expected to come into munis this year. And analysts think investors are becoming less discriminating about risk just as they should be on high alert.

The demand for all types of muni bonds has raised prices and lowered yields across the board. It has also narrowed the yield spread between high- and low-quality bonds. For example, Hallacy notes, over the past year, yields on 10-year California state bonds, which only carry an A+ rating, have dropped from 38 basis points above the average yield for AAA bonds to 8 basis points below it. The wider use of bond insurance is one reason why lower-quality issues carry a smaller risk premium than they once did. But analysts also think investors are ignoring potential credit problems.

To be sure, there are only a few cases of public defaults on investment-grade munis--New York City in 1975 and the Washington Public Power Supply System in 1983 being the most notorious. Governments can, in theory, always raise money through taxes. Yet analysts fear that investors, who mistakenly believe that their capital is safe, could lose lots of money if issuers are downgraded and the prices of weaker issues plunge.

Many investors are still desperately seeking a safe haven from the misery of the stock market. But the public sector can offer only so much succor. After all, it's only as financially solid as its citizens. And most feel pretty shaky right now.

By Dean Foust in Atlanta

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