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Warning: Stay Away From These Risky Bonds

Everyone is talking about them…

Warren Buffett

You can’t turn on CNBC or open an issue of The Wall Street Journal without hearing about them. Even Warren Buffett has made the headlines recently because of these “risky” bonds.

I’m talking about municipal bonds or “munis.” Lately, these bonds have been getting a lot of bad press…

“Muni Bonds: Riskier Than You Think” — Bloomberg

“Muni Bonds Not As as Safe as Thought” — The New York Times

“Troubled Muni Finances Lead Investors to Look for Red Flags” — The Wall Street Journal

What’s the deal? Historically, these have been some of the safest bonds investors could buy. In fact, prior to 2009, the historical default rate for non-investment grade municipal bonds was 2.7%, versus a default rate of 19.1% for similarly rated corporate bonds.

So what has changed?

Well, due to depressed property values (i.e. lower property taxes) and swelling pension deficits brought on by the “Great Recession,” municipalities across the country are verging on bankruptcy. In the past three years, the default rate for municipal bonds has practically doubled — from 2.7% to 5.4%.

The good news is if you still want to tax-free income, you don’t have to avoid municipal bonds all together. A few weeks ago, I showed you how you could minimize your risk by investing in a municipal bond fund. In case you missed it, you can read my analysis here.

But before you run out and buy just any old municipal bond fund, there is one thing you need to know.

See, even though city bankruptcies have been grabbing headlines recently. The biggest threat to municipal bondholders isn’t city finances, the recession, or the erosion of property taxes… it’s the declining rate of tobacco use here in the United States.

Let me explain…

In 1998, the four largest U.S. tobacco companies reached a legal settlement with states that were looking to recoup smoking-related health care costs. Per the agreement, the states would receive payments from the companies every year, based on the volume of tobacco sales.

Instead of waiting every year to receive their tobacco settlement money, a number of states issued tobacco bonds as a way to get more money upfront. In turn, tobacco bondholders would be paid with the actual tobacco settlement money as it was received.

In theory, it wasn’t a bad plan. In practice, tobacco bonds aren’t working out so well. Tobacco use in the United States fell far faster than anyone predicted. Many states are having trouble covering all the bond payments with the now lower settlement payments from the tobacco companies.

The largest municipal bond defaults are associated with tobacco bonds issued by California and Ohio. But almost every tobacco bond is a risky proposition.

In July, the ratings agency Moody’s predicted that 74% of the outstanding balance of tobacco bonds could default if cigarette consumption continued to fall at a 3% to 4% annual rate. Currently, 79% of the tobacco bonds Moody’s rates have a credit rating of “B1” or below.

Action to Take –> When considering a municipal bond fund, steer clear of any that have large holdings in tobacco settlement bonds. As smoking rates in the United States continue to fall, it’s likely the value of these bonds will go with them.

Related Tickers: iShares S&P Cal AMTFr Mncpl Bnd Fd (ETF) (NYSEARCA:CMF), Market Vectors Long Municipal Index (ETF) (NYSEARCA:MLN), PowerShares Insured Nati Muni Bond (ETF) (NYSEARCA:PZA), iShares S&P National AMT – Free Munpl Bd Fd (NYSEARCA:MUB), SPDR Nuveen Barclays Capital Municpl Bnd (NYSEARCA:TFI), Pimco CA Muni. Income Fund III (NYSE:PZC), PowerShares Insured Nati Muni Bond (ETF) (NYSEARCA:PZA).

This article is written by Amy Calistri, and was originally posted on StreetAuthority.

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