Municipal Bond Scare Stories Mask Strong Returns

PHOTO: In this Feb. 29, 2012 photo, a Stockton city worker walks away from city hall in Stockton, Calif.

Municipal bonds used to be the quintessential safe-but-dull investment. But ominous headlines about cities, recently including San Bernardino and Stockton in California filing for bankruptcy, have spurred some investors to rethink these investments.

Municipal bonds historically pay a lower rate of interest than taxable bonds because these returns are free of federal taxes and exempt from state taxes if the purchaser lives in the state of the issuer.

The recession of 2007-2009 and its protracted slow-growth aftermath have put severe financial pressure on governments, as higher unemployment has decreased tax revenues. That has led to a spate of municipal bankruptcies and, as a result, a general perception of peril for the muni bond market. In 2010, analyst Meredith Whitney spooked the muni bond market when she forecast "hundreds of billions of dollars" in municipal defaults.

Yet this hasn't been the reality. As of the end of 2011, muni bond defaults in the $1.3 trillion S&P Municipal Bond Index totaled .58 percent, with just over $1 billion in new defaults last year. Sure, that was painful for these investors, but even in this time of broke governments, it's the exception, not the rule. More than 99 percent of bonds issued by governments are still paying interest and principal to investors. That's a mere scintilla of the damage that Whitney predicted.

Moreover, even when local and state governments go belly-up for a time that doesn't mean they end up defaulting on their bonds. Under Chapter 9 federal bankruptcy, the local government or tax authority must present a restructuring plan to the court which could include delayed payments, reduced principal and extended maturities.

For example, Cleveland defaulted on its debt in 1978 but, by 1984, it had paid off the debt under court supervision. Cleveland's outcome, far more likely historically than default, shows that the greater risk is that investors may have their interest payments restructured – hardly the default scenario of lining up with other creditors to take pennies on the dollar.

While Treasury bonds are paying around 1 percent and bank CDs not much more than that, muni bond investors can reap relatively substantial tax-free gains. For example, State of California bonds due in 2036 were yielding 3.05 percent and bonds issued by Puerto Rico paid 4.35 percent, tax-free to residents. Those who can tolerate high risk can find bonds issued by authorities and small taxing districts paying 10 percent to 15 percent.

Compare that with Treasury bond yields – the one-year bond was yielding 0.15 percent—at the end of a year your $10,000 would have earned just $15 in interest, and you'd owe income taxes on that. Even the yields of 10-year Treasuries, which offer higher returns than their shorter-term cousins, paled in comparison with munis, returning only 1.72 percent.

Because of the over-reaction to doomsday predictions and the scary headlines about struggling cities, the yields on many muni bonds are substantial relative to their risks, given their performance thus far in this new era of governments in dire fiscal straits. Index returns for municipal bonds were 5.82 percent per year for the five-year period ending in July of 2012. The yield on the index was 3.27 percent as of the end of July. Over the same five-year period, the S&P 500 stock index returned 1.1 percent per year.

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