Wednesday, August 3, 2011 4:10 PM – Muni Scare

Are municipal bonds about to plunge in price? Meredith Whitney and some others think so. I don’t think so. First, let’s hear the bears’ case.

“There are about 45,000 municipal-bond issues in existence, with a market value of about $1.3 trillion, according to June 30 data from JPMorgan Chase & Co. About 7,000 are pegged to the same rating as U.S. Treasurys, and those issues could be downgraded in lockstep by the three key ratings agencies – Fitch Inc., Moody’s Corp., and Standard & Poor’s.”

Now, it’s my turn. The quote above is mainly referring to municipal bond issuers that pre-refund their bonds. Pre-refunding is the practice of putting aside the money necessary to pay off the bonds at maturity. The money is invested in US Treasuries. The bonds then get a AAA rating from rating agencies.

It seems reasonable that bonds covered by money set aside in US Treasuries would be AAA whether the Treasuries backing them are AAA or AA. The value is in the money being set aside, just so long as it is invested in safe securities.
Even if the US is downgraded to AA+ or AA those are still great ratings and the US can raise taxes to make good on its bonds. That is still high quality. I think the pre-refunded scare is false.

Will municipal bonds in general be downgraded if the US credit rating is dropped a half notch? Why should they be? The only reason to downgrade some state and local bonds would be if the feds decided to cut payments to the states. That could well happen but that is a separate issue from the US credit rating. The correct strategy in that case would be to concentrate on bonds in states not so much reliant on federal dollars. That argues for owning munis through a highly rated mutual fund with a reputation for great research.

I think a tax-free bond fund is a good investment now. Based on fear that in this case seems overblown, munis are probably under-priced.

For example, DWS Managed Municipal Bonds Class S (SCMBX), one of my favorites, pays 4.93% tax-free interest now. The only year in the last ten in which it had a negative return was 2008 when it is lost -5.4%. I would call that pretty low risk, especially these days.