With states strapped for cash, the tax-exempt bond market is feeling stress -- which means investors can find some good deals. By Jeffrey R. Kosnett, Senior Editor July 20, 2009 Tax-exempt bonds have been one of the safest places to invest through the recession. But it's time to ask how much more nasty economic news the market can handle before state and local bondholders get hurt.Right now 48 states are in the red, led by California, which is so broke it is issuing scrip instead of checks for tax refunds and some other expenses. Other big borrowers, such as Illinois, New Jersey and New York, are nearly as strapped. Budget gurus think states in general face even deeper budget shortfalls as a percentage of revenue in 2010 and 2011. Maybe the economy and employment will revive by then and relieve this pressure. RELATED LINKS Advice for California Muni Bondholders A Tipping Point in Bonds? But until it does, the municipal bond market will feel strain. Since May, when doubts about a quick economic recovery set in, tax-exempts have underperformed Treasuries and high-grade corporate bonds of similar maturities. Tax-exempts are not all losing value, but the total-return advantage municipals had over other kinds of bonds is melting away. The trouble isn't that any large number of issuers, and certainly no states or large state agencies, are actually missing interest payments. The few defaults this year have almost all been on bonds backed by hotel and land-development projects. Nor is it issuers getting downgraded (or are on watch to be downgraded) by the ratings agencies, though that is happening. Serious bond investors don't rely on ratings like they used to. They notice them, but they read financial statements and official reports and headlines -- and sometimes tea leaves -- and judge bonds accordingly. This makes yields and prices more subjective and less predictable. In stark terms, bonds are trading more like stocks. Advertisement Look at the action in a simple California state general obligation bond, one with a 5% coupon due to mature in 2034. If you or your mutual fund owns this bond, you will get paid. California's constitution puts only education ahead of bond debt as an obligation. There's no reason to sell a bond and take a loss if you can keep the bond to maturity and benefit from the income. But this market is increasingly unforgiving in the short run. 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 debt. As recently as February, it brought 92 to 94 cents. By June and early July, sellers got only 83 cents to 85 cents, for a current yield of 6.3%. That's the equivalent of 10.7% for California taxpayers in the highest tax bracket. The bond traded at a little higher price and a yield below 6% later in July as California politicians appeared to make progress toward a budget. This erosion of principal is bearable compared with outright disasters in REITs and oil and gas income securities that slashed dividends. States can't suspend payment of interest except as a last resort; they will borrow more, instead, and then at high rates. But it used to be rare for an investment-grade state bond backed by the power to tax to lose so much value in so short a time, no matter what's going on with the state's budget. And the wild trading isn't only a California story. So far in 2009 a bond of the Massachusetts Turnpike Authority due in 2023 with a coupon of 5.125% has sold between 77 and 96 cents on the dollar, a yield range of 5.5% to 7.8%. This bond is insured, though it is secured by highway tolls, not taxes. Its price is sensitive to what bond traders think will happen with truck traffic and other local economic indicators. Advertisement In general, the truth is that enough would-be municipal bond buyers are holding out for higher yields, using worries about state and local revenues and deficits as their excuse. Demand is especially soft from hedge funds and other financial institutions, says Bill Walsh, partner of Hennion & Walsh, a Parsippany, N.J., muni dealer and portfolio manager. Walsh says some individuals are buying, as they always will, because they assume personal tax rates will go up. With CDs and Treasuries paying so little, tax-exempt income has great value. But there aren't enough rich retirees to absorb all the bonds for sale. So the trend in yields is up. That means bond prices fall. This will level off only when big investors and institutions return in large numbers. We're getting there, but not yet, says Barnet Sherman, of Braintree Capital Partners, a private money manager in Braintree, Mass. Sherman, a former Morgan Stanley and Van Kampen muni fund manager, calls California's politics and finances crazy, but he says California has had 100 other financial crises but never real questions about paying interest on time. He figures a state general obligation or water and sewer bond below 90 cents on the dollar will recover to $1 or close enough, so buying now is safe. Find one around 80 cents and it's a steal. He's not the only old pro thinking this. But don't mess around with junk or low-quality municipals from California or elsewhere until the market calms.