When Buying Bonds, Muni or Not to Muni – What Investors Need To Be Aware Of

Tax free income may be one of the best and most coveted friends of this nations wealthy. Depending on what state you reside, you may get the benefit of triple tax free income, meaning federal, state and local tax exempt status. If you own bonds, muni or corporate, you must pay attention to the current environment as it relates to credit quality, interest rates and the future health of the issuers you own.

If you haven’t notices lately, the entire bond market has come under fire, and it’s worse if you’re a holder of muni bonds, their value has come down significantly. A fair proxy of the higher quality muni bond market is a basket of bonds traded as an exchange traded mutual fund (MUB). The current price of the fund reflects the downward pressure the bonds within the portfolio have experienced, and the chart speaks for itself. Issuers of muni bonds range from states, cities, counties, housing redevelopment projects, special purpose districts, school districts, public works projects, airports, port authorities and other government agencies that require funding to provide public services.

There seems to be an increasing concern over whether or not several of these issuers will be able to meet all their obligations in the future. The muni market is estimated at about $3 Trillion, not all or even the majority of issuers will face default or reorganization. However, small towns may begin to run out of options as it relates to providing services for their constituents and maintaining their payment obligations. As a potential red hearing, one of the wealthiest towns in New Jersey (Alpine), where tax rates are high and some of the residents are a who’s who, has been forced to outsource some of the necessary services such as fire and police to a nearby town called Tenafly.

This is a trend that seems to be picking up steam and becoming a more acceptable means of solving a short term revenue problem. If tax revenue doesn’t begin to increase in many parts of the country, you may see this trend continue, or take a more drastic turn. If you are a holder of small town muni bonds, be aware of the risks involved. Do not rely on the rating agencies that can give you a false sense of security that your bonds are of higher quality than they really are. Standard & Poors, Moody’s Investor Services and Fitch tend to downgrade bonds after the cat is out of the bag. They simply don’t have the resources to look into all the bonds they rate and their financial stability on a regular enough basis to be considered effective for investors to count on.

After all, they downgraded the Greece after they were deemed insolvent. That is not something you would appreciate if you were a holder of Greek bonds. Even some of the state sponsored muni bonds have come under fire and became the subject of various “avoid lists” published recently. Specifically, revenue short falls and budget constraints have hit California, New Jersey, New York, Illinois, Ohio, Michigan, Georgia and Florida. States are required by law to balance their budgets which is one of the reasons why part of the Federal stimulus package provided approximately $60 Billion to states in need, partially through the BAB’s program. (Build America Bonds) However, the total shortfall in 2010 is believed to be closer to $190 Billion. It will be interesting to see how the newly appointed house of representatives handles this problem in 2011.

It’s not going away without significant measures taken. Those that wish to protect their wealth should take a serious look at their bond portfolio and make sure they are invested in general obligation bonds and look to states that appear to be solvent such as Texas, Washington and Virginia. Lower yielding returns today may be a blessing in disguise if the problem throughout the muni market continues to deteriorate. Invest with Vigilance.

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