Muni Bonds Face Downgrade Risk

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Municipal bonds have long been the darlings of fixed-income investors, especially those in higher tax brackets. But “downgrade risk” now looms over this market, as state and local governments struggle to meet their muni obligations.

Many types of bonds and bond funds have been popular with investors over the past year or so, but tax-exempt muni bonds have been especially attractive. Investors poured about $72 billion into muni funds in 2009, swamping the $21 billion record set in 2006, according to Morningstar Inc. (Stock Quote: MORN), the market-data company. The average municipal bond fund has returned about 11.5% over the past year, according to Lipper, the fund-tracking firm.

Usually, the muni bond market is something of a yawner, and that’s just what muni admirers like. Munis aren’t as risky as stocks, and the federal tax exemption on interest earnings means investors get to keep all the interest earnings, while they can lose up to 35% of earnings to taxes if they invest in corporate or U.S. government bonds.

That’s made munis especially appealing to investors who worry that tax rates may rise when the Bush-era tax cuts expire at the end of the year and the government struggles with mushrooming deficits.

So what’s not to like?

Over the long term, munis can play an important, stabilizing role in a portfolio. But they are not completely immune from market jolts. Like other bonds, they are subject to a variety of risks, such as “interest-rate risk,” which causes the prices of older bonds to fall when newer bonds offer higher yields.

There also is “default risk,” when the bond issuer fails to make the interest and principal payments promised. Default risk is a serious issue with corporate bonds, especially high-yield, or “junk” corporates, because companies in trouble may stop making bond payments.

Default risk is generally not considered such a serious problem with municipal bonds because most are backed by the taxing authority of the city, county or state that issues the bonds.

Today, many of these issuers are running into financial problems as tax revenues sag because of the weak economy. Morningstar doesn’t expect a dramatic rise in municipal-bond defaults, but argues there could be a significant rise in downgrades. That’s when one or more ratings agencies suggest that a municipal bond is at greater risk of default, even if that risk is still fairly low.

A bond downgrade generally makes a bond less appealing to investors, causing its price to decline. When that happens to enough bonds, the net asset value of a bond fund can fall, offsetting the gains investors get from interest earnings.

Long-term investors learn to live with this kind of jolt. But Morningstar says many muni fund investors, like those who have rushed into other types of bond funds over the past year or so, may be expecting more safety than they will get. Many inexperienced bond investors were fleeing volatility in the stock market, or piling on as they saw healthy gains in munis and other types of bonds.

Performance-chasing isn’t usually a good idea, as it often means buying after the big gains are past. Investors who rushed into munis without carefully weighing the risks could face some unpleasant surprises in the short term, though munis should perform as expected over the long run.

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