Muni bonds: Now what? A checklist for investors

The plunge in tax-free municipal bond prices over the last three months has been unnerving for veteran and novice muni investors alike.

Last week, the market stabilized as buyers got more aggressive, lured by tax-free yields at two-year highs on some types of muni issues.

Whether this is the ultimate bottom in prices -- and top in yields -- is anyone's guess. The market also rallied in mid-November and again in mid-December, but those recoveries quickly sputtered.

Although the muni market slump started as part of a general sell-off in bonds in October, it quickly snowballed amid rising fears about the fiscal troubles of many state and local governments. That's the issue that has dominated the market this month.

Now what? For muni investors and potential investors trying to figure that out, here are four things to consider:

1) Last week's rally didn't move prices or yields dramatically. The point being, if you're looking to buy you can still find plenty of high-yielding bonds. And if you're looking to sell, you will still find bidders trying to low-ball you on price. There hasn't yet been a massive change of heart in the market place.

Munibb One measure of yields is the average of the Bond Buyer index of 40 long-term muni issues nationwide (charted at left). The annualized tax-free yield on the index peaked at a two-year high of 5.95% last Tuesday. It slipped to 5.85% by Friday, but still was up about a full percentage point since October. It's also more than a point above the current 4.57% yield on the 30-year U.S. Treasury bond -- the interest on which is federally taxable.

Among popular muni mutual funds, share price gains mostly amounted to less than 1% last week.

2) Muni owners would benefit from a reality check. Yes, the drop in bond prices has been painful on paper. The share price of one of the biggest muni mutual funds, the Franklin California Tax-Free Income fund,  sank 9.9% from Aug. 31 through Friday. But muni owners continue to earn interest income, which offsets some of that loss. In the case of the Franklin fund interest earnings have trimmed the net loss since Aug. 31 to 8.2%.

In a market like this you have to think about why you own munis. If it's tax-free income you want, you're still getting it. And if you buy now you'll be getting significantly more income than you would have locked in three months ago, even if this doesn't turn out to be the peak in yields.

As for the drop in bond prices, that has hurt recent buyers, but longer-term investors still are well in the black. In the two years ended last Thursday the average national muni mutual fund had earned 4.99% a year, counting principal change and interest earnings, according to data firm Reuters/Lipper.

3) Most state and local governments aren't going to default on their bonds. Not even Meredith Whitney, the Wall Street banking analyst who has become the muni market's loudest prophet of doom, ever said that most bonds were in trouble. She predicts defaults this year in the "hundreds of billions" of dollars. But even if that came to, say, $600 billion, it would represent 21% of the total $2.9-trillion muni market. That means most bonds would be money-good.

The fact is, the vast majority of muni issuers won't renege on their bond debts, because they know they need the market -- not vice-versa.

4) The near-term challenge for the muni market: The headlines probably are going to get worse before they get better. As I noted in my Times column on Jan. 15, conservative factions in Washington are pressing for Congress to pass legislation allowing the states to file for bankruptcy protection, a right they currently don't have (unlike many local governments).

Lockyer The states aren't asking for that law. California Treasurer Bill Lockyer last week called the idea "baloney." But then on Saturday Lockyer warned that the state might have to issue IOUs to pay vendors and other creditors as soon as April unless deep budget cuts are made between now and then.

Bond holders' payments are protected by the state Constitution, but still: Lockyer's warning will just feed the muni market bears and keep some potential buyers sidelined.

Likewise, there are painful budget choices ahead for many other state and local governments this year. But increasingly, the market now should be differentiating among muni issuers, separating those likely to face the greatest financial risk from those more likely to generate positive headlines than negative ones -- or as one investment manager recently put it, "sorting the sheep from the goats."

That's no simple task. It may be easier for many investors to evaluate the finances of companies than those of local governments. Remember the Securities and Exchange Commission's case against New Jersey last year, alleging that the state failed to properly disclose financial risks to its bond investors? That can't be an isolated occurrence.

Still, there is always opportunity in market chaos: Think of the corporate junk bond market two years ago and the stock market last spring. Somebody is going to make good money picking beaten-down muni bonds. How much time -- and courage -- do you have?