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How to Avoid Getting Burned By Muni Bonds

April 06, 2010 – by Richard Band

Municipal bonds used to be just about the sleepiest investment around. It was rare for a city or county to go broke, and states never did. Well, folks, that world has vanished with the dinosaurs. While I’m not sounding the fire alarm (yet) on munis, recent developments call for a much higher degree of vigilance. Absent some real, fundamental reforms in the way states and localities run their affairs, I think we could be grappling with an epidemic of municipal defaults in the next three to five years.

The problems are partly cyclical. The Great Recession of 2007-2009 caused state and local tax revenues to plunge, while spending on the social safety net continued to soar. The result? Budget deficits have exploded.

According to the Center on Budget and Policy Priorities, 13 states — Arizona, Colorado, Connecticut, Georgia, Illinois, Maine, Minnesota, Nevada, New Jersey, North Carolina, South Carolina, Vermont and Wisconsin — are expected to run up deficits exceeding 20% of their fiscal 2011 budgets. Imagine if your own income only matched 80% of your spending.

Unfortunately, there’s also a “secular,” or long-term, dimension to the crisis. Retired state and local government employees draw pensions and health care benefits — and most states haven’t salted away nearly enough cash to cover these promises. Some estimates put the unfunded liability as high as $2 trillion. The enormous tab for retiree benefits may well threaten the solvency of half a dozen states, plus hundreds of local governments, by the middle of the decade.

These grim statistics don’t mean you should run out and dump all your municipal bonds today. But you should think carefully about default risk before you plunk a dime into state or local IOUs. Ask yourself: Who stands behind these obligations? Can the issuer really pay, even in a bad economy? And most important: How do I get out if conditions start to worsen?

To protect yourself, here’s what I suggest:

Don’t buy individual munis. I’m not necessarily advising you to sell those you may already own, but I wouldn’t add to my stake. Individual bonds are difficult to sell in a good market, and almost impossible to unload when chaos reigns (as in the fall of 2008).

Favor open-end bond funds for new money. Open-end funds are traditional mutual funds that allow you to redeem your shares anytime at net asset value. In troubled markets, the liquidity afforded by open-end funds is priceless.

My favorite at the moment is Vanguard Intermediate-Term Tax-Exempt Fund (VWITX), which sports an average maturity of 6.3 years and a tax-free yield of 2.8%.

By sticking with intermediate maturities, you limit the risk of a sharp drop in the share price should interest rates spike. Minimum to open an account: $3,000. Buy at $13.60 or less.

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