Municipal bonds still safe, but a bit of caution helps
They are supposed to be among the safest, surest, most conservative investments you can make, in addition to being a great tax shelter. But people who have invested in municipal bonds must be wondering if they haven't been working under a false sense of security. Witness some recent developments:
* Several municipal bond issuers, trying to cut costs, are calling in their high-interest bonds and issuing new, lower-interest debt. Investors who thought they would collect on their municipal bonds for up to 30 years are learning that the life of the bonds has been cut to 5 or 10 years.
* Heavy publicity about the Washington Public Power Supply System (WPPSS), and the possible default on construction bonds for two terminated nuclear power plants, has challenged the principle of guaranteed payment of municipal bonds.
* Beginning July 1, all municipal bonds will be issued in registered form, as required by last year's Tax Equity and Fiscal Responsibility Act (TEFRA). Until now, ''munis'' came in coupon form and the investor clipped off a coupon every six months, took it to a bank, and either received cash or deposited the money in a bank account. Now, records will be kept of all municipal bonds and the investor will simply receive a check in the mail twice a year.
Registered munis fit in with one goal of TEFRA, that is, to make it harder for people to evade taxes through anonymity. With coupon, or bearer, bonds there is no record of who owns what bonds. The only thing an issuer knows is that certain bonds with certain numbers are ''outstanding.''
Many issuers, expecting investors will prefer bearer bonds, are rushing to bring bonds to the market before the July 1 deadline. The fact that interest rates are relatively low, compared with recent years, has helped the rush, too.
Some $450 billion in municipal bonds are outstanding, notes Peter Schmidt, a broker in the New York office of Prescott, Ball & Turben Inc. These outstanding bonds will still be good, making them one tier in a ''two-tiered market,'' he says. The other tier will be the new, registered bonds, which will probably have to carry a higher yield to overcome the loss of anonymity.
Apart from that loss, says James Lebenthal, chairman of a New York bond brokerage bearing his name, the loss of bearer bonds should be good for the market and good for the investor. He says it's a terrible nuisance ''to have to go to the safe deposit box, clip all those little coupons, put them in their own little envelopes, and then give them all to a teller to deposit. (Registered bonds) are much more in tune with the times for financial services.''
The times are also affecting people having their bonds called in by the issuers. With bond yields down around 9 percent, having to pay as much as 14 percent is just too much, and they're redeeming this old debt as fast as possible.
This makes it a good time to read the fine print on your bonds and see if they are ''callable.'' Some bonds can be called in anytime; with others, it can come after 5 or 10 years. If your bonds are callable now, contact your broker, who can quickly check to see if your bonds are among those recently called. Issuers do run ads in the financial press announcing bond callbacks, but these are easy to miss.
If you do not check occasionally, it is possible for the bank to accept a few of your coupons, then have to ask you to repay them for those coupons when it learns of the callback. This will come out of the bond principal when they are redeemed.
The bonds that seem most likely to be called are the housing variety, where state and local housing agencies issue 12 and 14 percent bonds to provide money for low-income and first-time home buyers. But with lower interest rates, many of these homeowners have refinanced at lower rates, leaving the housing agency with the long-term obligation, unless it can call in the bonds.
In the future, experts suggest that investors buy bonds that either are noncallable or have a long-call provision, like 10 years or more.
As for the uncertainty surrounding the WPPSS, or ''Whoops,'' utility system, that situation ''is certainly the most significant case the municipal bond system has seen in some time,'' Mr. Schmidt says. The problem with WPPSS, he adds, is that the people who care the most about seeing a quick resolution are the bondholders. ''There is not a strong constituency pulling for Whoops,'' he says, as there was for other once-troubled bond issuers, such as New York and Cleveland.
Still, he says, ''in terms of absolute default risk, the muni market has historically been a safe place to be,'' and changes under way in the business should not discourage prudent investors.
Despite this reassurance, Mr. Schmidt has some suggestions for people who want to be even more prudent. His first suggestion is to diversify. Keep a variety of bonds and a variety of types, such as utility, housing, municipal general obligation, and revenue bonds, in the portfolio.
Someone just starting out in municipal bonds may want to buy shares in a mutual fund investing in them. The rewards may be reduced slightly by management fees. But then, the risks aren't as great, either. And by studying the bonds and their issuers listed in the fund's quarterly reports, you can get something of an idea of how the bond market works.
Or you can try a unit investment trust. Usually sold in units of $1,000, these trusts are unmanaged portfolios of securities, municipal bonds in this case, that are held until maturity. Your broker should be able to give you a list of firms offering unit trusts.
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