Examine Risk with Municipal Bonds. (More Than Money)

Article excerpt

Municipal bonds often seem like a safe place for investors rattled by stock market losses to wait out the storm. The interest on these bonds has been exempt from U.S. income tax since the days in 1913, when the United States first imposed an income tax and states and cities gained a federal tax exemption for their bond issues.

According to a recent issue of Bloom berg Markets, municipal bonds have been a staple of finance since the Middle Ages, when Italian city-states sold securities. In the early 1800s, New York sold bonds secured by taxes on salt to build the 363-mile Erie Canal.

The recent volatile investing environment seemed tailor-made for municipal bonds. Their issuers sold a record $160.2 billion of bonds in the first half of 2002 to investors seeking both income and predictability. Private investors owned $572.9 billion of municipal bonds last spring.

It's interesting reading, but I strongly disagree with the Bloomberg author's conclusion that investors in these instruments may find themselves in a dark corner of the U.S. financial markets."

"The municipal bond market is worse than the Wild West," Kevin Olson of municipal-bonds.com is quoted as saying. He argues there are no laws or rules governing the municipal bond market and "no cavalry that will come to your rescue." His website offers free price data to investors and acts as a municipal bond watchdog, calling attention to spreads and disclosure issues and attempting to educate the public about municipal bonds. His special reports list "worst spreads" by quarter.

I think there is some merit to the criticism about lack of disclosure. In the stock market, the Securities and Exchange Commission requires public companies to disclose material news, but municipalities are exempt. Some effort is being made to correct the situation, with databases being set up through reputable sources, such as Bloomberg Municipal Treasury and Standard & Poor's J.J. Kenny Repository, to handle documents from municipal bond issuers and make them available to the investing public.

Most investors and investing professionals familiar with municipal bonds know the history has been long, but not perfect. In 1994, Orange County, California, filed the largest municipal bankruptcy in U.S. history. The county lost $1.7 billion and investors millions. Robert Citron, the then treasurer who caused the default by his speculative investments, was sentenced to a year in prison. At the time, the scandal was almost as shocking as Enron is today.

What are the problems Bloomberg cites with municipal bonds? The long "damning" list goes from inadequate disclosure and "always late" financial reports to no central exchange and high markups. According to the author, former SEC Chairman Arthur Levitt and his short-lived successor, Harvey Pitt, acknowledge reform is needed, but that "municipal investors may not get much help from the SEC." The reason: their plates are too full.

Do I agree this area of finance is not perfect? Of course. Are these criticisms overly alarming? I think so. Every investor in municipal bonds needs to know this is a complicated area. Each municipal bond issue is a "stand alone" investment with the terms of the contract spelled out in a lengthy, detailed prospectus. No two issues are exactly alike.

For that reason, the old, golden rule of investments applies: don't put all your eggs in one basket-diversify and reduce your exposure to any one issue or even geographic region.

Diversification is one reason municipalbond funds have been popular with individual investors. The five largest municipal-bond fund providers are Vanguard Group, Franklin Advisors, American Express Financial Corp., Scudder Asset Management and Fidelity Management and Research. The downside of a bond fund, however, is there is no "maturity date" or a given date that you'll be repaid, as with an individual bond. …