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Examine risk with municipal bonds. (More than Money).

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.

Municipal-bond funds are particularly appropriate for investors in high tax brackets who do not have many assets to invest in building a diversified portfolio. Bear in mind that in buying municipal bonds, a $25,000 bond is generally considered a "round lot" and anything less an "odd lot!' Investing in municipal bond funds avoids the problem of buying "odd lots." Young professionals still building their careers and salaries are an example of those who may be in a high tax bracket with only moderate investable assets.

In my opinion, the two greatest risks to municipal-bond investing are what they always have been: interest rate risk and legislative risk. With both, individual investors have very little control.

Interest rate risk is standard for investors in any kind of bond. If interest rates go up, bonds fall in price, and if interest rates go down, bond prices go up. The longer the maturity on the bonds, the higher the price risk.

It's absolutely critical that investors understand that municipal bonds are only attractive if you are in a high (at least 25 percent) tax bracket. Don't delude yourself that you are getting revenge on Uncle Sam by earning tax-exempt income. You are penalizing yourself, and forgoing real net (after-tax) income if you are not in a high-to-maximum tax bracket and you purchase municipal bonds or bond funds. This is a good time to consult your accountant.

I also mentioned legislative risk. This is very broad and runs the gamut from the municipal project itself becoming less solvent to your tax bracket changing, and can significantly impact the bond's attractiveness. When a "flat tax" was widely discussed in the mid90s, for instance, municipal bonds performed very poorly.

Something not addressed in the Bloomberg article is municipal-bond insurance, which generally provides excellent protection to investors. The insurers have enabled many issuers to fund projects they couldn't have otherwise and the insurance underwriting principle of diversification has made these insurance providers generally successful companies.

Really conservative municipal bond buyers insist on insurance, as well as a high financial rating on the underlying credit from independent credit-rating agencies. The ratings assess the issuer's financial strength and are worthy of attention in gauging credit-worthiness. The most broadly recognized credit-rating agencies for municipal bonds are Standard & Poor's, Moody's Investor Services and Fitch.

If you're considering municipal bonds, don't be spooked by the press, but keep in mind that rates are currently low and, as in all investments, knowledge, guidance and diversification are critical in making your choices.

Jeanie Wyatt, a member of the Texas Business Hall of Fame, formed South Texas Money Management in November 2000 after 25+ years experience in the banking trust area with three Texas bank holding companies. In 1998 she was appointed to the Texas Pension Review board; a year later she was appointed to the National Endowment Fund Board of Trustees of the American Red Cross, a fund that provides a permanent source of support for Red Cross services. Wyatt also served on the Board of Governors of the Association for Investment Management and Research (AIMR), an international organization of more than 100,000 investment professionals. A Charted Financial Analyst, she has an honors degree in actuarial science from the University of Texas at Austin and an MBA from the University of Texas at San Antonio. Her column, "More than Money," appears every other week in the San Antonio Express-News. She can be contacted at jwyatt@stmm-ltd.com.
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Author:Wyatt, Jeanie
Publication:The National Public Accountant
Geographic Code:1USA
Date:Apr 1, 2003
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