Bet On Muni Bonds
Fears that they'll default are overblown. Bet on them to outperform Treasuries in the near term too.

Municipal bonds and Treasuries have inverted their traditional relationship, with the former returning more than the latter. As a result, over the past several months more and more investors in long-term debt issues are looking to take advantage of this most unusual situation. And as for fears that municipals could default, the Forbes Investor Team says not to worry.

"We haven't seen such a rally for years. Yields are at their lowest point," says Matt Fabian, managing director at Municipal Market Advisors. And in the bond market when yields go down, prices go up. The tax exempted bonds yield has fallen 40 basis points in the last week. This rally is also helping those with lower-rated bonds unload them, Fabian says.

Historically, munis have yielded between 80% and 90% of Treasuries, says Annette Thau, author of the The Bond Book: Everything Investors Need to Know about Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More.

Recently however the yield on a AAA 30-year bond has increased to 114% relative to Treasury Bills. Currently A-rated 10-year General Obligation paper yields 150 basis points more than AAA GOs, according to Muni Market Data-line. The spread from AAA to BAA in 10-year maturities was 39 basis points at the beginning of 2007. Now the spread is roughly 350 basis points--a near-tripling in less than nine months, according to a recent report released by Citigroup ( C - news - people ).

The muni market has rallied in the past weeks after demand for Build America Bonds has increased. Under the new scheme the state and local issuers will get a 35% rebate on the interest costs over the life of the issue. California has already taken advantage of this vehicle and sold 5.23 billion Build America Bonds in just the passed week.

"This is compelling because it shows California has plenty of capacity to issue bonds and raise cash. If California couldn't issue debt it would be a catastrophe," says Christopher Ihlefeld, a managing director from Thornburg Investment Management.

Such figures don't necessarily mean that California, or any states saddled with debt, has a better credit rating. Issuers have been able to offer debt because they have better access to borrowing, not because their credit quality has improved. Still the danger of default is small.

"If the federal government is bailing out companies, they will bail out a state. Investors should look at the underlying credit and stick to liquid issuers," says Alexander Anderson, bond portfolio manager at the Los Angeles-based Envision Capital.

till, with unemployment soaring and property taxes decreasing, many municipal bond insurers are in increasingly difficult positions. Among the red-flagged states investors should keep an eye on are Florida, California, Michigan and Indiana, analysts say. Also, there could be automaker-related fallout in cities, counties, school districts and special districts located in Michigan (general obligation rated Aa3/negative outlook), Indiana (general obligation rated Aa1/stable outlook) and Ohio (general obligation rated Aa1/negative outlook), the Citigroup report shows.

"It doesn't mean that these states have more default risk. It is just that the liquidity is very low and there aren't many buyers," Fabian said.

On the flip side, some analysts still see value in bonds coming from distressed areas, with Detroit Water and Sewer as an example. A Detroit Michigan Water bond rated A2 by Moody's maturing July 1, 2010, was yielding 5.26%. Thornburg Investment Management has also invested in Las Vegas, which has been hard-hit by the slump in the housing market. "These are high quality bonds in distressed regions," says Ihlefeld.

Gerard Klingman, president of Klingman & Associates and a Forbes.com Investor Team member, believes revenue bonds from primary purpose type facilities, like bridges and tunnels, are safe investments along with bonds rated AA and above. He also likes General Obligation Bonds and "pre-refunded" bonds guaranteed by a portfolio of Treasuries.

Sectors that have been traditionally more risky are multifamily housing projects, industrial development revenue bonds, tobacco bonds, casino bonds and land development deals.

"I would be careful with hospitals, nursing homes and any land development bonds. I would invest in sewers and utilities. Even in bad times people are still going to flush their toilet," says Evan Rourke at MD Sass Muni Team.

You can invest here via exchange-traded funds, but some analysts recommend caution. The iShares S&P National Municipal Bond Fund ETF ( MUB - news - people ) offers a 3.6% yield this year but some believe it is not well diversified. "A couple of ETFs seem to have an over exposure. It's not easy to replicate the index they are tracking. It is very different from equities where the market allows you to purchase percentages. In our market it's not so cut and dry and there are numerous issues that go into the index," says Constantine Mallas, portfolio manager at T. Rowe Price.

So be cautious but not too cautious to invest here. Ronald Sloan, senior portfolio manager with Invesco AIM, says that Vallejo, Calif., offers an interesting study for those interested in municipal bonds. What happened in Vallejo is the municipality had a large round of contract renegotiations with its employees before the current economic meltdown.

Now that the state's been hit hard there is fear that it could default on its muni-obligations. But Sloan says that the city is currently trying hard to claw back some concessions made to the workers in order to pay back the muni-bond holders. "So, certainly investment grade and general obligation bonds are probably pretty darn safe," he says.

Bernie McSherry, senior vice president of Cuttone & Co., notes that these renegotiation efforts could potentially open a can of worms as municipalities consider suspending obligations from their own workers in order to meet their bond obligations.

This, of course, is terrible for these workers, but very good for investors in these bonds.

Backing Up Muni Bonds

Forbes: There's much recent talk of municipal bonds defaulting. How much of this is simply fear, vs. the reality of actual widespread default?

Gerard Klingman: I think what is a reality is, when you really talk about if you buy a investment-grade municipal bond, certainly general obligation, but even a necessary revenue bond, the likelihood that you will not get your interest and principal paid back if you hold that to maturity is very, very, very small. That doesn't mean in a financial crisis like we experienced that you will not have everybody flying away from anything that smells of risk and into Treasury bills paying zero return, that the value of them might not decline.

Bernie McSherry: Yeah, I think the interesting one is the case of the town in California. I think it's Vallejo … they're close to default. And they're trying to pursue a way of suspending their obligations to their pension funds for the municipal workers. And if that goes through, and early court cases seem to say that's a possibility, that could open a real can of worms across this country as towns and cities try to renegotiate existing labor maintenance.

Ron Sloan: Well, what happened in that particular case, because I'm from California, and Vallejo is not a town too far away, is they had accelerated a renegotiation of those contracts shortly before to the benefit of the pension holders, and made big salary increases to firemen and police in that town shortly before it became obvious that this was a city that was in financial trouble. So, what in effect the town is trying to do is claw back some of those maybe forward or honest, perhaps, negotiations with those municipal employees.

Klingman: What we're saying is that, in general, even municipalities that have difficulties, generally, they are going to find ways to deal with the financials short of not paying on their bonds.

Sloan: Yeah and, you know, in California the whole damn state's in trouble. But they just had a very successful bond offering … and we're already in junk status. And we have an oversubscribed offering of $6 billion. So, certainly investment-grade and GO bonds are probably pretty darn safe.

Klingman: I think, in general, municipal bonds, particularly general obligation, but even revenue bonds from primary purpose type facilities, bridge, tunnels, I think are very safe investments in general. And you know, the relative yields were more attractive a couple of months ago in the absolute depths of the crisis.

But, relative to Treasuries right now, if you're talking about five-year treasuries yielding under 2% and five-year municipals yielding, you know, 2.5% and they're tax-free. That's a relative value for a minimal amount of additional risk. Although, I will say you do have more liquidity, obviously, in Treasuries, in terms of if you need to sell them before maturity.