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Muni Bonds Redux

Chicken Little was wrong about municipal bonds and the funds that invest in them.

Sort of.

The sky didn't fall on municipal markets last year or this, but the weather sure did change in this once-sleepy sector for investing.

Nervous money, spooked off last year by banking analyst Meredith Whitney's prediction on the 60 minutes TV show of widespread defaults, is now flocking back to the tax-free debt of cities, states and other public entities such as colleges and toll bridges.

"Many people were making claims that in 2011 there would be billions of dollars of defaults in the municipal market and that the world was going to end," said Bill Walsh, chief executive of the wealth management firm Hennion & Walsh. "It didn't happen."

However, money managers are discovering that if they want to make money in this evolving market, they'll have to cultivate underutilized skill-sets.

Namely: keeping perspective, acquiring a really good sense of timing and paying attention to details.

Appetite is growing, according to the Investing Company Institute. Municipal bond funds saw $1.38 billion of inflows the week ending Feb. 22 and $1.13 billion the week of Feb. 29. The week of March 7 saw another $1.66 billion come in, with $1.32 billion flowing in the week of March 13th.

This once would not have been surprising.

Municipal bonds were considered a safe, if boring, choice for wealthy and risk-allergic investors to park their money and earn tax-free yields. No one had to worry about the fundamentals of most issuers because they received insurance wraps that automatically gave the bonds AAA-credit ratings.

"Almost two thirds of the market had triple-A insurance. The golden rule was that you didn't have to think about them and could sleep at night," Oppenheimer Funds vice president and senior portfolio manager Troy Willis, said. "For decades, people were buying municipal bonds without any understanding of the underlying credit."

Then the credit crisis came and most of the large bond insurers, which had big sub-prime mortgage businesses, got in trouble. MBIA and Syncora both had to restructure themselves and pull out of munis, while Ambac and the parent of FGIC both went kaput. Assured Guaranty is the only big "monoline" insurer left in the game.

Throw in the recession's impacts on public budgets, as well as banking analyst Whitney's televised prognostications, and investors yanked $33 billion from the market during the three months ending January 2011.

Then the Apocalypse failed to show, and people started to appreciate perspective.

For example, the market was never as risky as people imagined. According to Willis at Oppenheimer, the triple B-rated muni market, over the past forty years has had a lower default rate than triple-A corporates.

"You can buy lower rated muni bonds with professional management with extra yield, and can dip down a level in credit quality without taking on a whole lot of credit risk," he said.

It still provides big tax advantages, according to Mark Martiak, senior vice president at Premier/First Allied Securities. A 5% New York municipal bond offers a return equivalent to an 8.8% taxable coupon if you live in the city.

"The technicals still remain very positive for municipals going forward," said Martiak.

This renewed appeal is causing a problem though. Wealthy investors, who tend to hold their own bonds, represent the biggest competitors to fund managers. In fact, retail investors account for perhaps 70% of municipal ownership, says Martiak.

Also, as governments clean up their fiscal houses, issuance has slowed. Public entities generally issue about $400 billion annually. This year, experts say issuance will be well below $300 billion.

That means more money chasing fewer coupons. Bargains are going fast.

"All of this money is coming in at a time of low supply, when yields are low. Investors are not buying into the best time. They are possibly overpaying," said Miriam Sjoblom, a bond fund analyst at Morningstar.

Oppenheimer manager Willis, who manages roughly $32 billion of assets in 15 state-specific municipal bond funds and 5 national municipal bond funds, is working his competitive advantages to find the best bargains.

"We are able to buy bonds that retail investors can't get," he said. "We have access to other avenues compared to a lot of retail buyers."

Managers need to do more research, according to Eric Friedland, director of municipal research at Schroder Investment Management.

Friedland said that municipal debt carries a lot of opportunities, but the class is painted by the mainstream media with a wide brush. People don't realize that there are a lot of different sectors in the asset class: utilities, universities, states, local governments, airports, toll-roads, and seaports.