5 Reasons Not to Panic Over California Bankruptcies

Municipal bond investors quake out west.

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Don't look now but there really has been an unusual string of bankruptcies in the muni market.

Is this the tsunami that analyst Meredith Whitney forecast more than a year ago? Investors pulled billions from munis in late 2010 and early 2011 after she predicted that hundreds of billions of dollars in municipal bonds would default.

Three California cities, two of them with populations of about 200,000, have opted for Chapter 9 bankruptcy filings in recent weeks, and other cities across the country like Scranton, Penn., are using emergency measures to avoid a filing.

The quick series of defaults in California surprised some people, and revved up the old worries that cities and towns are in big trouble. Experts remain unconvinced.

"It's really not widespread," says Peter Hayes, head of BlackRock's municipal bonds group. "These are not one-off things, but they are isolated."

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To be sure, he said, many local governments are having difficulty funding basic services, and getting less help from state and federal sources.

Blame the Great Recession for the country's fiscal problems. For local governments, the problem is more directly linked to housing collapse. Property taxes fund over two-thirds of the cost of local government and education, and shrinking revenues are just now starting to have an impact. "It does not happen automatically," says Hayes. "There is a cycle to it."

Investors, however, are showing no concern. Lipper reports that there have been inflows every week this year to municipal bond funds, with nearly $1 billion added in the latest week. Is this yet another sign of a market unhinged? Is it time to panic? No, but it could be time to tread more cautiously. Here are alternatives for getting past the crisis without a panic, and perhaps adding some bargain munis to your portfolio:

1. Focus on investment choices that you can control. The economy and housing prices will follow their course. You cannot change that. "People have to be selective when they buy. These (municipals and state bonds) used to be thought of as commodities, all alike and all safe. But that's just not true," says Gabriel Petek, a state credit analyst for Standard & Poor's. The old assurance that munis never default simply does not hold anymore—in fact it never did. The Municipal Markets Advisors reports some $6 billion in bond defaults last year in the nearly $4 trillion market.

Risky ventures and overspending caused some failures. If you manage your own money, you might want to avoid the more esoteric corners of the muni market. A double-digit yield on, say, a new bond based on tobacco lawsuit revenue, might seem appealing, but the risks—for example, a drop in the cigarette sales that support the bond—could be a larger worry. Or, if your town is overloaded with cavernous shopping malls, investing in parking-lot bonds for the new megaplex could be a star-crossed venture.

2. Ignore the rhetoric of political budget battles. With municipal budget battles raging all over the country, cities are threatening bankruptcy as a way to curb unions and pull back on costly pension commitments.

But as cities and towns see cash resources drain away, the last thing they want to do is cut off credit lines. They are slashing salaries, pensions, and services first—not bond payments.

"People should be careful about reacting to all of the headlines," says Hayes. "These situations are complex." Each of them requires research, and Hayes touts the work of his own muni team at ferreting out the good from the bad, an important exercise when there is such diversity in the offerings. Many financial advisers say diversified funds are the best way for most people to invest in munis.

[See Top-Rated Municipal Bond Funds.]

3. Remember that California's fault lines do not run from West to East. In fact, in economic and political terms, the state really is an island (in addition to sitting on a tectonic plate that drifted in from the Pacific.) The bankruptcy-hit towns of San Bernadino, Stockton, and Mammoth are relatively affluent. But their real estate values plummeted and none can boost taxes enough to pay the bills.