5 Questions to Ask About Your Muni Bonds

07/28/2011 2:30 pm EST

Focus: BONDS

Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Not all munis are bad choices, but the bad outnumber the good and it's best to do your homework. In this exclusive interview with MoneyShow.com, Marilyn Cohen of Bond Smart Investor runs down her list of questions any muni buyer should ask.

Marilyn, you've warned for a long time about risks in the muni bond market, and recently Meredith Whitney, who has gotten a lot of publicity about this, has doubled down her prediction that there are going to be a lot of defaults in the muni market in coming years. What do you think?

I don't think her notional value of $200 billion to $400 billion is going to be correct, but I was ahead of the curve regarding Whitney.

When I wrote my book Surviving the Bond Bear Market last summer, I devoted several chapters to a bear market in muni credit, meaning downgrades. Howard, just recently, Moody's had downgraded 3.91 downgrades in muni land to every one upgrade.

Although it's very quiet out there right now in muni land, sub terra there's a lot going on, and it isn't good because the credit metrics continue to deteriorate.

Interesting. So, what do you see? A lot of retail investors kind of abandoned the market late in 2010 through early 2011. Are they starting to creep back in, or are they still staying away from munis?

Let me qualify that. They abandoned the municipal bond fund sector of the market. Massive outflows. When we're speaking today, there have been 25 consecutive weeks of outflows out of municipal bond funds.

But the investor that held individual bonds has held on and been a net buyer. They don't want to, it seems to me plain and simply, have to count on other people staying in the fund to prop up the net asset value.

Individual securities can be purchased with impunity as long as individuals do their homework, like anything, and be very selective and don't throw the baby out with the bath water.

But go through a hit list of things that you want to make sure your munis have:

  • Do they file financials annually?
  • Have there been any material events?
  • Which material events mean something has gone wrong?
  • Can you connect the dots for how the revenues are generated and then passed through to you, the bond holder?
  • Have there been any interest rate swaps?

Should we also look at the state of the municipality; for example, the state of Illinois, which is in very bad shape, or California, which is in very bad shape versus I don't know, Indiana, which is probably in very good shape? Should people be using those kinds of things as well?

Absolutely. I have ratcheted down my California exposure just because is California going to default? No, I don't believe that for a minute, but the headline news is always bad and for people to be in municipal bonds for safety and security, you don't want to live through those headlines.

You go with good quality, good states. Indiana is one of them. Tennessee is another. Florida is another. Their financial wherewithal is significantly better than Illinois, which is on the bottom of the barrel; California, which is right on top of the bottom of the barrel with Illinois.

Why subject yourself to that? You're not getting paid for it. It's not like you're going to double your rate of return by being in one of those states that is subject to headline news risks. You want to be very, very prudent.

I started doing my reallocations a year and a half ago and that's why I thought if I'm doing this, I better tell everybody they better do it too and that's why I wrote the book, Surviving the Bond Bear Market.

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