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Muni bonds fall out of favor

Marketplace Staff Dec 12, 2008

Muni bonds fall out of favor

Marketplace Staff Dec 12, 2008


Tess Vigeland: This year forced many of us to question where exactly is a safe place to park our cash.

Yes, if your bank is FDIC insured, you’re safe, but it’s still disconcerting to watch the likes of IndyMac go under. Yes, the government is now guaranteeing money market mutual funds, but for a few days in September you had to wonder. And now there’s a bit of drama surrounding municipal bonds. Investors are refusing to buy them, so prices are tumbling.

John Waggoner is a mutual fund expert with USA Today.

John, what’s behind the selloff?

John Waggoner: The reason they’ve had problems is because of the credit crunch. People who are lending money only want to lend money to people who will absolutely no kidding really guaranteed give it back to them. And that’s why this week we saw investors were willing to accept a zero yield for investing in the United States Treasury because all they want is their money back. They don’t care about no stinkin’ interest.

Vigeland: So they have been fleeing from muni bonds just like every other investment?

Waggoner: Absolutely right, and it’s had a lot of bad effects, one of which is that it’s much harder for states and towns and counties to raise money for things they might need like schools and roads and water systems.

Vigeland: Well, how rational is this flight? Are muni bonds still a good investment even though people are dropping them left and right?

Waggoner: Oh yeah, they’re excellent investments. In fact, they have a much better track record for repaying investors than corporate bonds and it’s extraordinarily rare for a municipal bond to default. It’s big news when it happens. Look, we’ve been through a period when all kinds of terrible things have happened that we didn’t expect, but by and large, I would say that muni bonds are an exceptionally safe bet.

Vigeland: Let’s talk about the difference in risk between a muni bond mutual fund versus buying them individually.

Waggoner: Here’s the difference: if you buy a muni bond, you’re agreeing to lend to, say, the state of California, $1,000 at a set rate of interest. So every six months, you’ll get an interest payment from California provided they don’t default and at the end of 10 years, you’ll get your money back. A muni fund is basically when people pool their money together to buy a whole bunch of different municipal bonds, somtimes from different states, sometimes of different maturities and different credit qualities, and the idea being is that, OK, supposing California defaults on one issue of its bond, hey, you’ve got 50 other bonds and so it’s going to be only 1/50th of your portfolio and you don’t really stand any big chance of loss.

Vigeland: Unless everybody goes running for the exits.

Waggoner: Yeah, in which case you have other things to worry about like why is there no state government anymore.

Vigeland: I’ll give you that it’s really probably unlikely that states are going to start defaulting all over the country, but in this era right now, is anything really impossible?

Waggoner: Well, no, and that’s a good point and that’s one reason why you might not want to invest in individual bonds, because the temptation always is to buy the bonds with the highest yield. Well unfortunately, the ones with the highest yields are trying to entice you to buy them because they have really rotten credit ratings. It’s like lending to two people: either your wonderful brother Sam, who’s a Ph.D. and has a zillion dollars, and your no-good nephew Fred. You might get a higher rate of return from your no-good nephew, but how long is that going to go on before he splits for Vegas. So what people often fall into when they try to buy individual bonds, they say, “Oh, I’m going to get this nice fat, juicy yield” when in fact they’d be better with what’s called a general obligation bond, which is issued by the state itself, it’s backed by the taxing authority of that state. The odds of that defaulting are very low indeed.

Vigeland: John Waggoner is the chief mutual fund reporter at USA Today and also the author of “Bailout: What the Collapse of Bear Stearns Means for Your Personal Finances.” Thanks so much for your time today.

Waggoner: Hey, my pleasure. Thank you.

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