If most of your clients decide to "stand pat" with their municipal portfolios after you cover these issues, I will be amazed, and so, perhaps, will you.

The Five Red Flags

For five specific reasons, some municipal bonds may not be as rewarding in the future as they have been in the past.

Red Flag #1 – The CDO Woes of Municipal Bond Insurers

More than $1 trillion in outstanding municipal bonds are covered by the credit enhancement of municipal bond insurance. This year, just over 50% of new muni issuance includes insurance.

In return for a premium that averages about 40-50 basis points, the insurance upgrades a bond's rating to triple-A – the rating earned by all leading muni insurers – which allows the bond issuer to access debt markets at lower cost. The insurance covers any default of interest or principal for the life of the bond.

The largest insurers include four heavyweights: MBIA Corporation (MBI: $3.0 billion in estimated current-year revenue), Ambac Financial Group (ABK: $1.6 billion), MGIC Investment Corp. (MTG: $1.6 billion) and Assured Guaranty Ltd. (AGO: $350 million). A fifth participant, Financial Guaranty Insurance Corp., is a privately-held company with annual revenue of about $500 million. The first insured municipal bond was underwritten by Ambac in 1971, and for more than two decades these "monoline" insurance companies specialized in insuring munis. However, in recent years they have begun to enhance a variety of structured credit and mortgage-backed products, including collateralized debt obligations (CDOs). Now, the monolines are mired in financial problems related to the collapse of the subprime mortgage market and its knock-on effects on CDOs.

In a recent report, Eagan-Jones Ratings Co. estimated MBIA stands to lose $20.2 billion on its guarantees and securities holdings while losses at Ambac and MGIC are projected at $4.3 billion and $7.2 billion, respectively. The rating agency added in this assessment: "There is little doubt that the credit and bond insurers face massive losses over the next few quarters and many will be capital-challenged."

Separately, Fitch Ratings served notice in early November that it will review the capital condition of municipal bond insurers to determine if they still warrant an AAA-rating. It is possible that ratings agencies may require the monolines to produce substantially more capital to maintain the highest rating. But raising capital may be made more difficult by operating losses that public-company insurers have reported for the most recent fiscal quarter, combined with deterioration in their stock prices. For example, the $20.2 billion that Eagan-Jones expects MBIA to lose is almost five times the company's stock market capitalization of $4.2 billion. MBIA shares have lost more than half of their market value in the past six months, and the company reported a pre-tax loss of $352 million for this year's third quarter.

What would a ratings downgrade of leading municipal bond insurers mean to the market? The answer is unclear, except to say that the possibility creates a large cloud hanging over it. Potentially, a downgrade could turn some triple-A rated insured bonds into double-A or worse and produce sharp price declines in their prices. It also could damage monoline insurers' ability to attract new underwritings.

Red Flag #2 – The Davises of Kentucky

A retired couple from Kentucky, George and Catherine Davis, have thrown a potential monkey wrench into the market by suing their state. They contend Kentucky has no right to impede interstate commerce by granting state tax exemption to residents on in-state bonds while denying tax-favored treatment to out-of-state bonds. In 2007, a Kentucky appeals court ruled in their favor, and the state has appealed to the U.S. Supreme Court, where the case is expected to be heard in 2008.

What would happen if the High Court lets the Kentucky decision stand? Potentially, all municipal bonds could become equally attractive ("double/triple tax-free") for any resident of any state. New York and California munis, especially, benefit from having a large captive market of affluent investors motivated to buy in-state bonds. Analysts believe a Davis win could reduce prices of some NY and CA bonds by 3-5%. Huge amounts of assets now held in state-specific muni funds also could be subject to redemptions, because these funds would no longer hold any special advantage for investors.

Red Flag #3 – Arnold's Axe, Florida's Falloff

In early November, California Governor Arnold Schwarzenegger ordered all state departments to develop plans for spending cuts, to avert a potential state fiscal deficit this year of up to $10 billion. California's budget woes are directly related to a downturn in the housing market, and they indirectly reflect weaker general economic conditions.

California accounts for about 20% of all municipal bond issuance in the U.S., and is the only major state that does not qualify for at least a double-A rating from one ratings agency. Unless California can resolve its deficit crisis, there is growing concern that its rating could decline further, setting off a chain reaction of losses in the muni market.

Other states also have budget problems linked to the housing crisis. Florida is facing a $1 billion deficit in the current fiscal year. Earlier this year, Michigan lawmakers averted a statewide shutdown of government services by increasing personal income and sales taxes to fill an $800 million deficit. Maryland is reported to be running $1.7 billion in the red this fiscal year.

According to the National Conference of State Legislatures, all states combined had a surplus of $58.1 billion in fiscal 2006. But overspending and tax shortfalls will reduce states' collective coffers to $54.1 billion in 2007 and a projected $41.0 billion in 2008. If the U.S. economy tips into recession, many state budgets will come under pressure and some states could see their General Obligation bond ratings downgraded. Florida's economy has been especially hard-hit by the housing downturn, which has already created a sharp slowdown in state tax revenues. Florida is the only large muni bond issuer with a triple-A rating, but that could be in jeopardy if the state's fiscal dilemma does not improve.

The table below summarizes states with the largest muni issuance.

Sources: Securities Industry and Financial Markets Association and Nelson A. Rockefeller Institute of Government.

* Growth in second-quarter 2007 revenue over second-quarter 2006, adjusted for new legislation and inflation.

** Second quarter 2007 over second quarter 2006, not inflation-adjusted.

Red Flag #4 – Revenue Bonds

The general obligation (GO) bonds backed by states are relatively safe compared to revenue bonds. These bonds are often backed by user fees or special tax levies, not state government promises and general tax revenues. Given the downturn in residential real estate and the emerging weakness in commercial real estate, it is likely that some revenue bonds will feel ripple effects. For example, industrial development bonds are used to build infrastructure such as water, sewerage and roads for new residential and commercial developments. But if the developments are under-utilized or abandoned, the revenue streams supporting bond interest/principal payments may fall short.

Revenue bonds now account for about two-thirds of total muni issuance, and more than half of revenue bond issuance qualifies for a triple-A rating, usually achieved with insurance. About one-third of revenue bond issuance is unrated or has a rating that can't be identified.

In the six years since 2001, total annual U.S. revenue bond issuance has more than doubled, from $186 billion to a projected $420 billion this year. There is little doubt that the explosion in revenue bond issuance has been driven by a seemingly infinite amount of bond insurance capacity.

Red Flag #5 – Remember Orange County?

The last big trauma experienced by the muni market was 13 years ago, when the Treasurer of Orange County lost $1.5 billion investing county funds in a leveraged repo market scheme. When Orange County declared bankruptcy, the fallout roiled the entire muni market nationwide.

Recently, the market for asset-backed commercial paper has experienced dislocations due to financial problems in structured investment vehicles (SIVs). So far, the news media has not reported any large losses by municipalities in asset-backed commercial paper. But it is well known that some municipalities have invested surplus funds in the commercial paper market to capture higher yields.

In addition, some city and county governments have participated in the CDO market with long-term assets such as pension funds. Announcements of municipal investment losses linked to CDOs may yet be in the pipeline.

Five Key Questions to Ask Clients in Muni Reviews

1. How important is safety of bond principal?Remind clients that the "baseline" of safety-consciousness is set by U.S. Treasuries bought and held to maturity. To accept more risk, the investor should believe that a bond can deliver incremental yield, return or tax benefits. In normal markets, the risk-return tradeoff is easier to assess than in "red-flag markets." If clients can't afford to lose any principal, muni holdings should be confined to top-quality GO bonds held to maturity. Prices of long-term revenue bonds may be especially vulnerable to any setbacks in the broad muni market.
2. Do you really need municipal bond insurance? For perhaps the first time ever, insurance enhancement has become a double-edged sword. If even one monocline insurers is downgraded, all insured bonds could feel the impact. By switching from an insured bond (or fund) into an uninsured equivalent, it isn't clear that clients are giving up quality in today's market.
3. How much exposure do you have to the "Big Three?" The big three are the two states that would be most affected by a Davis victory (NY, CA) and the one state already in a recession, Florida. So far, prices of GO bonds issued by these states have held up fairly well in the market, but that may not continue. California is double-vulnerable to an adverse Supreme Court decision and housing-led recession.
4. Have you checked your TEY lately? Taxable equivalent yield (TEY) tells investors the yield they must earn in a taxable bond to equal the after-tax benefit of a tax-exempt muni. For example, if an investor is in a 32% federal/state bracket and can invest in a muni yielding 4.0%, the taxable bond would need to yield 5.88%. Over the past six months, muni yields have remained relatively flat while yields on many high-quality corporate bonds have increased. Ten-year corporate bonds rated triple-A or double-A now yield 5.5% to 6.0%, while Bloomberg's average yield on 10-year insured revenue bonds was only 3.97%. Considering the red flags on both insurance and revenue bonds mentioned above, it isn't clear that earning 3.97% in these bonds is worth the risk.

5. Are you sure "tax-exempt interest" is 100% taxable? This question is most important to retired people because their municipal interest can effectively become taxable in two ways: 1) by increasing the taxable portion of Social Security benefits; and 2) by increasing Medicare Part B premiums under the new income-relating provisions that took effect this year. For details, see:

Help Your High-income Senior Clients Plan for New Tax Complexities

Also, income from private activity bonds can have tax impact for clients who are subject to the Alternative Minimum Tax. Help clients check the 1099s that they receive from brokerage firms or mutual funds, reporting interest from private activity municipal bonds.

A Time for Calm Caution

Should all investors who own municipal bonds or bond funds be concerned? Yes.

Should they make haste to sell out muni portfolios before a red flag hits? No.

The muni market has become like an old familiar friend to many people, and it will continue to offer select opportunities that match personal financial goals of high-income clients. However, every market goes through periods of change or turmoil.

The global credit market has entered such a period already. The municipal bond segment is not immune to troubles, and it will probably have its days in the headlines. Help your clients make preparations now so that tomorrow's headlines are yesterday's news.