Finding the Right Bonds for You

By: Dr. Jay H. Abrams
Chief Municipal Credit Analyst

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In these challenging economic times, many investors want to know: What guidelines can be employed in selecting muni bonds that will help ensure a safe, steady stream of tax-free income?

While it is hard to make general rules, there are certain timeless principles that make sense to follow. First, keep in mind that obligations of state governments are almost universally going to be paid on time, regardless of financial pressures. California, the poster child for a state with financial challenges, has a provision in its state constitution requiring the payment of educational funding first, debt service second and all other state obligations after that.

In their credit analysis, rating agencies have long recognized the breadth and diversity of state economies, revenue streams and semi-sovereign powers. The average state bond rating is “AA,” which recognizes the extreme unlikelihood that a state would fail to meet its debt obligations.

Essentiality

A second guideline is the importance of the project being financed and its continued operation. Projects involving the health and safety of a community have funding priority in tough times. General government, water and sewer facilities, and hospitals fall within this category. While it is extremely rare for any municipal bond to default, essential services need to continue and officials in charge have, in the past, done all within their power to see that funding is available for both service delivery and the payment of debt service.

Third, issuers who can make adjustments in the services they offer have flexibility to reduce money losing operations in favor of increasing those that are profitable. Medium grade hospitals, for example, can reduce those health services that are financially troublesome while offering services like OB/GYN that may increase the hospital's bottom line.

G.O. bonds have strongest pledge

A fourth, and perhaps most important, rule is to examine the security behind the bond. General obligation bonds, with their unlimited taxing power, have the strongest pledge amongst municipal bonds. In good times and bad, this places such bonds at the front of the line for payment, regardless of how financially strapped a local government may be. For non-G.O. bonds, one must be mindful of how economic cycles affect the pledged revenue stream.  For example, in troubled times, bondholders should see little impact on utilities providing water and sewer services.

Finally, bonds with diverse revenue streams supporting repayment insure that if one source of payment dries up, others remain available. Such bonds are known as "double barreled" in the municipal bond industry.

Added layer of safety

Don’t ignore bond insurance. While the municipal bond insurance industry has seen its ratings fall dramatically in the last couple of years, most bond insurers are still rated within investment grade categories. Investment grade indicates that rating agencies are still confident the bond insurers will meet their payment obligations if called upon to do so.

At one time, bonds were bought based on the high rating of the bond insurer. Today, we would suggest the underlying credit be the focal point on which a credit quality evaluation is based. Nevertheless, a bond with insurance provides an added layer of safety.

No investment is riskless

Overall, these strategies can help, but the potential always exists that, despite the best efforts of the issuer, events beyond its control could have a negative impact on performance.  In general, however, these guidelines can help the investor be more risk averse from a credit perspective.

6/3/2009