Muni bonds still safe, tax-free option despite doomsday talk

— -- Jefferson County, Ala.'s November decision to file for bankruptcy could have sent the municipal bond market into a frenzy. But just as the muni market fended off dire predictions of spiraling defaults during the height of the credit crisis, tax-exempt bond issuers have continued to hold their own through a recession and tepid recovery.

Only three municipal bond issuers (out of a universe of about 50,000) have defaulted in 2011, according to ratings agency Standard & Poor's. While reduced tax revenues put pressure on state and local government to meet their obligations, municipal bankruptcy is rarely an option for legal, financial, and practical reasons.

Debt service on municipal bonds tends to be one of the top spending priorities in state budgets, most of which must be balanced annually. Municipal interest and principal payments are not that onerous, representing less than 10% of total government spending in all but three states in 2010 by S&P's count. Plus, the mere threat of not honoring their debt commitments could cause municipalities to lose the trust of investors, cutting off a vital funding source.

"A muni default has to be a really poor situation,'' says Tom Weyl, director of municipal research for fund manager Eaton Vance. "There was a spike at the beginning of the recession due to project finance risk in community development districts in California and Florida. Most (issuers) that are going to default have already done so."

Budget crisis as wake-up call

In fact, market watchers say state and local budget crises have served as a wake-up call for municipal issuers to get their financial houses in order. Pension reform and other spending cuts combined with an expected rebound in tax collections have most state balance sheets in their strongest financial shape since the start of the recession in 2007. California, for instance, is slated to spend the lowest amount as a percentage of personal income since 1973.

"States have done a much better job over last two to three years than in past economic downturns,'' says Weyl. "Addressing the problems was already going on when the over-hyped (default) predictions came out."

A stronger economy should lower defaults in general, but investors can further mitigate risk by focusing on a bond's payment source.

General obligation municipal bonds that are backed by the taxing power of the issuer are a safer bet to honor payments than revenue bonds that rely on usage fees and other payments for services such as toll roads and airports.

Elle Kaplan of New York's Lexion Capital Management recommends investing in bonds of municipalities providing essential services like water.

For investors convinced the municipal bond market is back on solid footing, these securities provide handsome tax advantages. Municipal bonds partially offset higher tax rates by sheltering interest income from federal income tax.

At the current top federal tax rate of 35%, a muni bond yielding 3.9% would produce the same tax equivalent yield as a taxable bond yielding 8%. In high tax states, owning muni bonds exempt from state and/or local taxes can offer even greater tax savings.