When buying bonds, it's a time to be picky

As the effects of the financial crisis spill over into state and local governments, municipal bond investors need to be more selective than ever. With mounting layoffs, business closings and foreclosures, the tax base of most government entities has been shrinking. "We've had to increase our scrutiny," says Rob Boeck, senior managing director of Nicollet Investment Management. "We look very closely at the number of foreclosures in the area, the per capita debt and the debt load of the city, county or school district that is issuing the bonds."

He typically avoids bonds issued by governments in areas of high foreclosures or mounting debt. He also tries to avoid areas that may have one large employer that could create an economic hardship for the area with a large round of layoffs.

"We're still buyers of municipal general-obligation bonds, but we prefer the higher-rated ones," says Boeck.

Boeck also doesn't put his entire trust in the rating agencies. He does his own due diligence to make sure he is comfortable that the taxing entity will be able to raise the revenue necessary to keep up with the bond payments.

Municipal bonds are typically most attractive to individuals in the highest tax brackets because the bond interest is exempt from federal income tax and often state income tax as well. But the returns are nothing to write home about. Most AA-rated municipal bonds are paying around 1.6 percent. That is a higher rate than you could get with most Treasury issues, but it is still low compared with some other income-paying investments.

"Most investors would probably do better by buying negotiable CDs or highly rated corporate bonds where they can get a yield of 3 to 4 percent," says Boeck.

If you do buy munis, Boeck offers one other recommendation: Think short-term. "We've shortened the maturity on all the bonds we're buying because we believe that the Obama stimulus plan will lead to higher inflation and that will cause interest rates to rise. We should be able to get better rates in the next two or three years."

"Of course it will have an effect," says Mark Hoonsbeen, principal of Edina-based Nicollet Investment Management. "They're pumping $1 trillion into the economy. The bigger question is whether or not it is an effective policy. In the past, these types of policies have not been very effective."

Stimulus plans didn't work in Japan

Hoonsbeen points out that Japan tried eight stimulus plans without success. "Nothing worked until they finally addressed the core problem, which was cleaning up the balance sheets of their banks."

The big difference between this plan and Japan's failed efforts is that the U.S. package is much larger, which should have a quicker, more dramatic impact on the economy.

"The question is, will the stimulus package create a base of sustainable economic activity?" says Hoonsbeen.

Hoonsbeen says that every dollar spent in the economy has a multiplier effect because those dollars are passed along to buy other goods and services. "I would contend, however, that the multiplier would have a greater impact if it were spent by the private sector rather than the government."

One potentially positive development, according to Hoonsbeen, is that we may be near the end of the subprime mortgage problem, although if unemployment continues to climb, the rash of foreclosures could continue. "But if the employment rate stabilizes, you will see an improvement in the foreclosure problem."

Another positive is that business inventories may not be the drag on the economy that they had been in other recessions. "I think overall, businesses went into this downturn with less inventory than they usually have entering this type of economy," says Hoonsbeen. "Consider Kohl's department stores, for instance. Its sales were down in the fourth quarter, but its growth margins were up. Why? Because it didn't have so much inventory that it had to discount its merchandise."