EnvisionCap.com: Forbes Article

Muni Opportunity

Marilyn Cohen, Forbes Magazine, 01.08.07

For municipal bond investors, the Nov. 3 headline in the Chicago Tribune was apocalyptic: "Illinois Pension Nightmare." Seems that the pension fund for state workers and teachers is short $45.8 billion. Illinois is hardly alone. Rhode Island, Connecticut and Oklahoma are among those in the pension stew. Each has over-committed and underfunded its obligations, a reflection of how easy it is for politicians to appease workers now while leaving the costs to be picked up by future generations of taxpayers.

Pensions are only half the picture. State and city governments have also made hundreds of billions of dollars in promises to cover retiree health benefits. They haven't come close to setting aside the money needed to cover benefits already earned.

The reason taxpayers have only an inkling of this health care funding hole is that states and cities were never required to report the cost calculations. As of Dec. 15, though, that changed. New accounting rules require cities and states to report their nonpension retiree obligations. The numbers will be devastating.

What do you, the investor, do about such a dark situation? Wait a bit before adding to your muni portfolio. These bonds soon will be cheaper and will deliver higher yields.

But if you are a buy-and-hold investor, which is the best approach to bond investing, it's a pretty good bet that you can ride these bonds to maturity without fear of default. The historical default rate for full-faith-and-credit munis is infinitesimal. (We're not including the riskier variety, "revenue" bonds that fund enterprises like parking garages.) Worst case, look at the biggest muni wipeouts in recent times: the defaults of New York City in the 1970s and Orange County, Calif. in the 1990s. After all the shouting subsided, bondholders got back their principal. There were also some Whoops bonds from Washington State that caused investor losses in the 1980s. These were revenue bonds tied to power plants.

But today's muni issuers with underfunded pension liabilities are in sound financial shape. The state of Illinois has an AA credit rating. So the response of Illinois and the others to the pension shortfall will be to issue more bonds. The increase in supply will lower muni prices generally and boost yields. Even if your town's pension system is in pristine shape, its bonds will be a buying opportunity.

After investors absorb the reality of underfunded pensions, they will resume their buying and prices will recover. Expect an added stimulus over the next several years as investors anticipate higher tax rates. Taxes on (nonexempt) interest, dividends and capital gains rates will eventually go up. That will make sources of tax-exempt interest all the more valuable. You want to get into munis long before that happens.

A 4.1% yield for a 12-year insured AAA municipal bond translates to a 6.3% taxable equivalent yield for investors in the highest federal tax bracket (now 35%). Aftertax, munis already beat the socks off taxable alternatives: Treasurys, corporates, mortgage-backed securities and government agency paper.

What should you be looking at?

An exception to the rule that revenue bonds are potentially hazardous has to be made for water and sewer munis. Example: Cape Coral Water & Sewer 4.25%, due 2020. This Florida community's $185 million issue, priced a hair above par, is rated AAA, is Ambac-insured and yields 4.1%. As we said above, for someone in the top bracket this is equivalent to a taxable yield of 6.3%.

Another extremely safe approach is to buy any school district municipal bond from Texas that is Permanent School Fund guaranteed. The Texas Permanent School Fund, enriched since 1854 by the sale and lease of public lands and mineral rights, lends an AAA quality to any bond it backs. Example: the Pflugerville Independent School District 4%, due 2018, a $40 million issue that came to market in October. Priced at 99.95 cents on the dollar, this bond yields 4%. That's a 6.15% taxable equivalent yield for the 35% bracket.

Don't be put off by the small issue size. Most PSF-guaranteed munis are smallish. Still, these babies are as safe as any bond carrying insurance from the likes of Ambac.

Lastly, purchase general obligation bonds issued by your state, especially if it has its own high taxes. The New York General Obligation 4%, due 2019, is priced at 99.5 to yield 4.05% to maturity. A New York City dweller faces a combined tax rate of 44% (net of the benefit from deducting state taxes on the federal return). He would have to earn 7.2% on a corporate bond to do as well. The muni carries an AA- rating. It's a good buy for that investor despite the city's generous pensions.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.