More investors saying "no thanks" to muni bonds

Is this an interesting trend to pay attention to, or merely a short-term phenomenon all but forgotten by Labor Day? MS

(Reuters) - Warren Buffett isn't the only investor sounding alarm bells on municipal bonds.

A growing number of U.S. investors are either scaling back or dumping outright their positions in what was long considered the least volatile and safest of markets.

So far this year, municipal bond funds have enjoyed $5.1 billion of net new cash while U.S. government agency and Treasury bond funds have taken in $9.1 billion, extending a record-breaking year for bond funds and exchange-traded funds of $396 billion in 2009, according to Lipper.

The tax-exempt muni market has sheltered investors from the sovereign credit storm so far this year: Total returns year-to-date are 3.54 percent while the benchmark Standard & Poor's 500 index .SPX is down about 5 percent through July 7. For their part, U.S. Treasuries prices are up 6 percent for the same period, according to Barclays Capital.

But as financial markets enter the second half of 2010 with risks of a "double-dip" recession growing, U.S. investors are bracing for even harsher fiscal deterioration at states and localities and, consequently, are shying away from the $2.8 trillion municipal bond market.

"The balance sheets of corporate America are in much better shape than that of our governments, states and localities," said Tom Sowanick, chief investment officer of OmniVest, which oversees more than $1 billion.

"We are completely out of munis, and we don't plan on buying any even though some are yielding more than 5 percent. No thanks."

Sowanick said the relative performance of municipal bonds has been "nothing less than horrible." The total returns for munis between the March lows of 2009 and June of this year were 13 percent, while corporate bonds turned in 28.6 percent.

Christine Todd, a managing director at Standish Mellon Asset Management, said she has been scaling back the level of risk in her portfolios. "General obligations are of the highest quality but with GOs come more economic and political risk," she said. "We took down our exposure there and have gone into revenue or so-called essential bonds."

Revenue bonds are paid from the revenue usually generated from a particular public project, such as a road or a sewer system. General obligation bonds are backed by the full-faith and credit pledge of the issuer, and by extension, the ability to raise money through taxes.

Some mom and pop investors, too, aren't sticking around in the second half. U.S. municipal bond funds reported $232 million of net outflows in the week ended June 30 -- marking the first weekly outflows since mid-April, LipperFMI reported late last week.

A $140 BILLION PROBLEM
The Center on Budget and Policy Priorities said last week that U.S. states in fiscal 2011 could be facing the worst budget situation since the recession began in 2007. The cumulative budget shortfall of states "will likely reach $140 billion in the coming year, the largest shortfall yet in a string of huge annual gaps that date back to the beginning of the recession," according to the think tank.
Fiscal 2011 began one week ago for most states, which have turned to another round of cuts and tax increases to try to wipe out the gap. All states with the exception of Vermont must balance their budgets.

Concerns about budget deficits and funding shortfalls will probably lead to market-value declines in the municipal bond market and, perhaps, widespread defaults, technical analyst Robert Prechter said in a recent interview.

Conversely, U.S. corporations, not counting financial companies, have socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26 percent from a year earlier and the largest-ever increase in records going back to 1952, according to the Federal Reserve.

'TERRIBLE PROBLEM'
It is "one of those rare times -- approximately once a century -- when (munis) are at serious risk of default," Prechter said. "The whole municipal area is likely to see a decline in price and a rising yield ... over the next several years."

The amount of debt in municipal bond defaults continues to lag those of corporate debt this year, with 19 muni defaults totaling $1.028 billion through June, compared with eight corporate defaults totaling $2.787 billion, said Richard Lehmann, publisher of Distressed Debt Securities Newsletter. For all of 2009, $108 billion of corporate debt defaulted versus only $6.3 billion of munis.
While most of the muni defaults this year continue to be from risky Florida community development districts, Lehmann said he foresees more defaults as issuers struggle with climbing employee pension costs.

Billionaire Warren Buffett warned the Financial Crisis Inquiry Commission in June that municipal bonds faced a "terrible problem." He has trimmed his investments.
"There will be a terrible problem, and then the question becomes will the federal government help," Buffett said at the hearing. "I don't know how I would rate them myself. It's a bet on how the federal government will act over time."

Tom Metzold, co-director of municipal investments at Eaton Vance, overseeing $7 billion, said he is holding and buying high-quality revenue bonds for larger essential service projects. "People will still need electricity so they can watch TV, and they'll need to pay for water if they want to take a bath," Metzold said. "That said, I'd rather have the GO of Massachusetts than the water and sewer revenue bonds of a small town where the consumer demand is not very high."