With many states facing budget shortfalls, tax-exempt bonds are taking a hit. By Jeffrey R. Kosnett, Senior Editor August 5, 2009 For the most part, municipal bonds have been a haven during the recession. But with many state and local governments facing dire budget problems, it's time to ask how much more nasty economic news the tax-free market can handle. California, one of 48 states whose budgets are in the red, is so broke that it is issuing IOUs instead of checks for tax refunds and other obligations. Other big borrowers, such as Illinois, New Jersey and New York, are nearly as strapped. Experts see states facing even deeper budget shortfalls (as a percentage of revenues) in 2010 and 2011. Soft market. Eventually, the economy will be in better shape, which will mean lower unemployment and higher tax revenues. But until then, the muni market will remain soft. Since May, when doubts about a quick recovery set in, tax-exempts have lagged Treasury and high-grade corporate bonds of similar maturities. No states, and few municipalities, have actually missed interest payments -- municipal defaults aren't much more common than dodo-bird sightings. And it's not a matter of investors reacting to downgrades by rating agencies. Serious bond investors don't rely on ratings as they used to. They know the ratings, but they mainly read the headlines and issuers' financial statements and then judge bonds accordingly. That makes yields and prices (which move inversely to one another) more subjective and less predictable -- or in stark terms, more like stocks. Look at the action in a California state general-obligation bond maturing in 2034 and bearing a 5% interest coupon. If you own this bond -- still rated A by Standard & Poor's -- and hold to maturity, you will almost certainly get what you're due. When it comes to meeting obligations, California's constitution puts only paying for education ahead of repaying bond debt. Advertisement But it's another story if you have to sell before maturity. In the summer of 2008, California's fiscal troubles were evident, but sellers of this bond still got 97 cents to $1.02 per dollar of face value. As recently as February, it traded at 92 cents to 94 cents on the dollar. By mid July, sellers got only 83 cents to 85 cents, giving the bond a current yield of 6.3% (equivalent to 10.7% before taxes for the wealthiest Californians). Wild fluctuations aren't confined to California debt. In the first half of 2009, a Massachusetts Turnpike Authority bond due in 2023 with a coupon of 5.125% sold for between 77 cents and 96 cents on the dollar, its yield ranging from 5.5% to 7.8%. Highway tolls, rather than taxes, secure this bond, but it is insured and has an underlying rating of A from S&P. One reason muni-bond prices have been weak is that many potential buyers are holding out for higher yields, using worries about state and local revenues as their excuse. Demand is especially soft from hedge funds and other financial institutions, says Bill Walsh, a partner at Hennion & Walsh, a Parsippany, N.J., money manager and muni-bond dealer. Walsh says some individuals are buying regardless of the price and yield because they assume that income-tax rates are headed up. But there aren't enough rich retirees to absorb all the bonds for sale. So the trend is for higher yields and lower prices until institutions start buying in large numbers. WeUre getting there, but we haven't arrived yet, says Barnet Sherman, of Braintree Capital Partners, a money manager in Braintree, Mass. Sherman, a former Morgan Stanley and Van Kampen muni-fund manager, calls California's budgetary and political stalemate meshuga (that's Yiddish for crazy). But he adds that although the state has seen dozens of financial crises, it's hard to go wrong with buying a California general-obligation bond or a local water-authority bond for less than 90 cents on the dollar; if you find one for 80 cents, it's a steal. But until the muni market calms down, don't mess around with low-quality municipals from California -- or anywhere else.