Quotes of the Day

Municipal bonds have long been a no-brainer investment. But not any more. A growing number of analysts and financial planners are raising doubts about the bonds of local and state governments. They worry that a weakened economy, along with rising cost of benefits for city workers, will make it tougher for local governments to meet their obligations.

"Munis don't offer the same sleep-at-night safety they used to," says Christopher Cordaro, a financial planner at Regent Atlantic in Morristown, NJ. Earlier this year, Cordaro, who has been a planner for 22 years, began advising clients for the first time in his career to trim their muni bond holdings. "Municipalities across the country are in rough shape." (See TIME's "25 People to Blame for the Financial Collapse")

Cordaro isn't the only one having doubts. Last week, ratings agency Moody's lowered its outlook for the debt of local governments to 'Negative.' In its report, the ratings agency said local governments face "unprecedented fiscal challenges," over the next 18 months. The report also noted that this was the first time Moody's analysts were broadly worried about the ability of local governments to pay back their debts. Among the places Moody's finds to be most troubled are cities in Florida and California, because of the real estate bust, Indiana, Michigan and Ohio, which are being hurt by the drop in manufacturing, and Connecticut, New Jersey and New York, due to the financial crisis.

The debt of municipalities has long been a staple of many investors' portfolios. Financial professionals and their clients have been lured by munis' tax-free status, a history of few defaults and nearly three decades of low single-digit annual returns.

In the past two years, however, munis' predictability has been replaced by volatility. The bonds of state and local governments were among the worst performing sectors of the debt market in 2007, before falling off a cliff last year. The average muni bond fund lost 9.4% in 2008, and there were ten funds that lost more than 15%.

At first, the losses did not really unnerve muni investors because they stemmed from a special problem relating to muni bond insurers, such as MBIA, which ran into financial difficulty. For that reason, many analysts and investors saw that early selloff in munis as a buying opportunity. The insurers may be in trouble, the thinking went, but municipalities were still able to raise taxes, or tolls, if they ever got into a crunch.

But as the economic crisis unfolds it's getting harder to make the case that the financials of local governments are sound. "We know that there is going to be a number of states that will have problems balancing their budgets," says Diahann Lassus, a financial planner in New Providence, NJ.

Unemployment, which hit of rate of 8.5% last month, is higher than it has been in 25 years, and sales taxes are plummeting. Worse, local governments on average get nearly three-quarters of their tax revenue from real estate assessments. Falling property values and rising foreclosures mean that source of revenue is drying up as well. Many local governments have built up reserves anticipating the downturn in the housing market, but Moody's says that might not be enough. "The sharpness of the housing downturn and speed of the general economic contraction will likely test the sufficiency of those reserve cushions," Moody's analysts wrote.

While the revenue of state and local governments are falling, their obligations are not. On average, states have funded only 83% of what they owe or will owe to their retired workers. Many states have done a much worse: West Virginia, Road Island, Connecticut and Oklahoma all have less than 60% of their retiree benefits paid for. "The number of state funding ratios at the low end is startling," says Peter Hayes, who heads BlackRock's municipal bond management committee. "The prospect for even greater liabilities is a reasonable scenario if the country becomes trapped in a prolonged recession."

Last week, New York City said that it would have to cut thousands of municipal workers to keep the city from going bust. "We cannot continue," NYC mayor Michael Bloomberg told reporters. "Our pension costs and health care costs for our employees are going to bankrupt this city," he said.

Because of these issues, muni bonds don't seem particularly cheap even though munis now yield more than Treasuries. Indeed, Gary Strumeyer, head of capital markets at Bank of New York Mellon, says munis are no longer in the same rock-solid category as Treasuries, so it's not even a fair comparison. "Every investor needs to understand the many risks associated with purchasing muni bonds these days," he says.

Instead, Strumeyer believes investors should compare muni yields to those of high-quality corporate bonds. Recently, Vanguard's Term Tax Exempt fund, a huge muni fund with $21 billion in assets, had an implied yield of about 3%, according to Regent Atlantic's Cordaro. A similar corporate bond fund, BlackRock Intermediate Bond II, had yield of 8.5%. Even assuming a 35% tax bracket, the corporate bond fund is yielding nearly double the muni fund.

"I am not sure how some people say muni bonds are cheap," say Cordaro.

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• Stephen Gandel