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Municipal bonds provide safe haven for wary investors

Many classes of bonds are being punished for the problems of subprime mortgage debt, but at least one segment of the market is expected to perform well this year -- long-term, investment-grade municipal bonds.

The US$2.6 trillion municipal bond market is generally considered safe as Treasuries because most local governments make debt payments their top fiscal priority. Even New Orleans met obligations on its bonds after Hurricane Katrina.

Munis, as they are known, are issued by cities, counties, states, water districts, schools and hospitals. They are popular because of their safety premium and because they create funding for favorite local projects. But their biggest selling point probably is many are not taxable.

"If you want to buy a defensible asset that hasn't rallied, munis are the place to be," said RJ Gallo, a portfolio manager at Federated Investment Management Co.

Investors are also buying munis because they are aware that assets backed by bad mortgage debt remain unattractive.

But muni prices have come under pressure of late, as they get tarred with the same brush as riskier credits. Many analysts think munis are unfairly being caught up in the problems of the insurers that back about 40 percent of this market.

Bond insurers like Ambac Financial Group Inc and MBIA Inc remain in limbo as they scramble for the financing that would allow them to operate as usual, while FGIC is considering a split that will separate the healthy municipal bonds it backs from subprime assets.

The market's problems have also contaminated an unlikely niche of the municipal market, auction-rate securities. This US$330 billion short-term muni bond market segment normally performs like clockwork. But this week queasy buyers went on strike, leading to hundreds of auction failures, because troubled insurers back many of these deals.

The auction failures were unprecedented and left short-term financing in disarray at schools, student loan companies and transportation authorities around the country. An auction failure does not throw the securities into default, but it does drive up borrowing rates severely, since the interest rate on such instruments changes every time they are sold -- and soars if they are not sold.

In the last few days, the Port Authority of New York and New Jersey saw its short-term interest rate on some notes increase fivefold to 20 percent after a failed auction, while a Michigan student loan program suspended operations to avoid the higher rate.

Yet throughout the insurers' drama, strong demand persisted for top-quality munis. This is because the selloffs sent prices lower and yields higher, making them a good buy.

Investors' comfort with munis sometimes is enhanced by the fact that they finance local institutions and projects they can track.

About 35 percent of municipal bonds are purchased by investors with direct knowledge of local issuers, Gallo said.
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