Orange County Woes Prove Green For Munis $1 Billion Bankruptcy Isn’t The Disaster Some Feared

The next time sudden disaster strikes a mainstay of the municipal bond market such as Orange County, Calif., buy shares of muni bond funds.

That idea may strike you as illogical, if not downright foolish. But it would have been the right way to play the strange sequence of events that has unfolded over the past three months.

On Dec. 1, Orange County made the bombshell disclosure that it had lost something more than $1 billion on bad investments. A few days later it filed for bankruptcy protection.

The national and California markets for municipal bonds were quickly convulsed by uncertainty.

But rather than a prelude to defaults and a collapse of confidence in the debts of state and local governments, those developments marked what now looks like the end of the 1994 bear market for munis and other types of bonds.

In the weeks that followed, bonds rallied as interest rates fell. Municipal bonds performed the best among the major classes of bonds, and California bonds performed the best among the major classes of municipal bonds.

As Russel Kinnel, an analyst at the Morningstar Mutual Funds service in Chicago, put it: “‘Unlucky’ investors who bought shares of a California muni bond fund the day before the first report of trouble in Orange County had, on average, a 6.9 percent return (through Feb. 16) to show for it.

“National muni funds gained 6.2 percent, while U.S. Treasury funds gained 3.3 percent,” he added.

What happened to produce this downside-up outcome? First, efforts to keep Orange County’s woes from spreading, or leaving bond holders with permanent losses, appeared headed for success.

Secondly, the Federal Reserve neared the end of a year-long campaign of tightening credit conditions.

Finally, the supply of new municipal bonds coming into the market, which had been weighing down prices for most of the past couple of years, contracted abruptly.

Although munis have now demonstrated their ability to rally in the face of adversity, two clouds loom.

Congress may lower taxes, thus making tax-free income less valuable, Kinnel said. And the Fed could raise rates again, hurting short-term returns.