Munis Weather the Storm

"We're broke." Words to make you cringe if you invest in municipal bonds and the speaker is the mayor of a city to which you have lent money. In this case, the speaker was Ray Nagin, mayor of hurricane-ravaged New Orleans. Fortunately for investors, private insurance companies back virtually all of the bonds issued by New Orleans and its agencies.

Rarely have the benefits of municipal-bond insurance been so clear. After Hurricane Katrina devastated coastal areas of Louisiana and Mississippi, insured municipal bonds issued in those states lost 1% to 2% of their value. But uninsured bonds from those areas sank 5% to 7% from pre-Katrina prices. And that's just for bonds that traded. Many uninsured bonds haven't changed hands, says Chip Peebles, a senior trader with Morgan Keegan in Memphis. What they're worth is a mystery.

Holders of uninsured Gulf Coast tax-free bonds may need patience and strong nerves to weather the financial storm following the meteorological one. Investors in bonds issued by the states of Louisiana and Mississippi should do fine. Those states appear strong enough to meet their obligations. But some battered counties, parishes and agencies, such as toll-road authorities, may have trouble paying interest. "Some may miss a payment or two," says Dennis Porcaro, a Morgan Keegan muni-bond analyst.

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But muni holders have an ace in the hole: Just as New York City financed much of the post-9/11 reconstruction with munis, so Gulf Coast municipalities will need to raise tens of billions of dollars with new tax-exempt bonds. Uncle Sam and the states will almost certainly help local governments make payments so they can demonstrate their creditworthiness. "I can't imagine that local governments will be allowed to default without state or federal intervention," says Reid Smith, who manages five Vanguard muni funds.

Katrina offers clear lessons for investors. If you buy individual munis, stick with insured bonds, which automatically qualify for AAA ratings. They yield less than uninsured bonds, but you'll sleep better. If you want to boost yield by investing in lower-grade IOUs, make sure you own bonds from a variety of states. And if you're a fund investor, don't limit yourself to state-specific funds.