Muni Bond Strategy Is Buy High (Quality), Sell Low

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Municipal bonds face trouble ahead that one expert compares to lava flowing from a volcano—that will ooze into the fixed-income sector.

The $3.4 trillion muni industry faces a multitude of threats, ranging from the high-profile financial problems of big cities to tax challenges resulting from Washington budget negotiations.

Consequently, Marilyn Cohen, president of Envision Capital Management, is advising clients to take the unusual step of buying high and selling low.

"That is, only buy high quality municipal bonds and sell the low-quality munis you own," Cohen advises in the most recent edition of her Bond Smart Investing newsletter.

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The guidance comes from a view that the higher-risk bonds that investors bought in a quest for yield will come back to haunt them as municipal financial pressures mount.

"The great American municipal bond restructuring is selectively in process—like a slow lava flow," Cohen said. "Run away and sell those issues that may scorch your portfolio."

Among the biggest targets are Detroit; Stockton and San Bernardino, Calif.; and Chicago; as well as Puerto Rico. Each has struggled with moderate to severe difficulties. Detroit teeters on bankruptcy, and Chicago has one of the slowest growing city economies in the country. San Bernardino has filed for bankruptcy protection, and Stockton is eligible to do so.

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"The sound and fury, posturing and bluffing may appear a bit different in each case, but the subliminal outcome is the same: bondholders must share in the pain and take a haircut," Cohen said. "Like a lava flow, taking a haircut on your municipal bonds—even one position— is destructive. But like a lava flow, casualties should be rare because the information and process is slow enough to allow escape."

The muni market survived a scare in 2010, when banking analyst Meredith Whitney famously predicted widespread calamity and dozens of huge defaults that never materialized. Munis went on to perform superbly but have slowed recently.

The Barclays Municipal Bond Index is up 1.4 percent for the year, worse than even the 1.52 percent return from Treasurys and well below the 8 percent return of the Barclays Composite Index.

Mutual funds focusing on munis have taken in $8.34 billion this year but have lost more than $1 billion over the past six weeks, according to the Investment Company Institute.

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In addition, munis face political obstacles in Washington. Congress is toying with capping municipal tax deductions at 28 percent, which critics say would be harsh on the industry and the governments that use the bonds to fund their operations.

Threats of removing the tax-exempt strategy had previously not been taken seriously, but they are now.

"State and local government issuers are facing a clear and present danger that the IRS code relating to the tax exemption will be changed so as to make financing more costly," Citigroup muni analyst George Friedlander said in a research note. "The timing of any such change is uncertain."

Friedlander said, however, that the move probably wouldn't take effect until late this year or 2014.

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But he said the damage would be substantial, because the government is relying on inaccurate models to project the actual costs.

"The costs of such changes to issuers appear to be severely understated relative to potential benefits to the federal government, because they rely upon a flawed model for assessing the cost of the tax exemption and for assessing how changes in the tax exemption would affect borrowing costs," Friedlander said.

Cohen also expressed concern about the tax problem.

"There's enough municipal bond consternation going on that you can't control," she said.

_By CNBC's Jeff Cox. Follow him on Twitter at @JeffCoxCNBCcom.