Munis Carry Risks And Opportunities

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OCEAN CITY – While historically less volatile than stocks, bonds nevertheless have been affected by the turmoil in global economies. But lately some investors who fled equities have been giving muni bonds, with their tax-free advantages, a second look. Given current economic conditions, they want to know: Are munis safe?

Michael Sullivan, Director of Municipal Marketing for Merrill Lynch, recommends focusing on quality. “The time may be right to consider buying high-quality municipal bonds, with underlying ratings of high single A or better,” he said. Historically these bonds have low default rates and provide better liquidity during volatile markets, he says, adding that lower-quality bonds present higher risks. With the economy slowing down, municipalities could face lower revenues, putting pressure on issuers’ budgets. This may result in increases in credit downgrades and default rates of low-quality debt.

But how can you spot quality? The best way, Sullivan says, is for investors to seek bonds that are backed by broad-based, secure revenue sources. The safest choices are general obligation bonds, backed by the full taxing power of municipalities. They are considered the most secure because municipalities must raise taxes to support interest payments on the bonds. Other safe securities include bonds backed by sources of revenue from essential services, such as water and sewer systems. “Communities will do what is necessary to keep essential-service bonds from defaulting,” Sullivan explains.

He recommends that investors work with their financial advisors to check the underlying rating of the issuer when considering a muni bond. Look for issues with underlying ratings of AAA by Moody’s and/or Standard & Poor’s. Next on the quality ladder are AA and A. “All of these can be sound choices when combined with strong sources of revenue,” he says.

Market conditions may make this a good time to buy high-quality munis that suit your investment objectives. Increased risk aversion among institutional investors, coupled with the need for liquidity, has resulted in sagging demand for bonds, including munis. The lack of this demand has caused yield spreads to increase as sellers offer bonds to the market.

While municipal bonds are not immune from market conditions and are subject to market risks, there are significant opportunities in the muni market. Consult your financial advisor for more information.

(A Merrill Lynch senior financial advisor. She can be reached at 410-213-8520.)

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