Muni Bonds Weather the Storm

Hurricanes Katrina and Rita have inflicted major damage to bridges and roads across the Southeast. But municipal bond fund managers say the bonds supporting those structures are not buckling. In fact, they may even be bargains.

"There are numerous cases of happy endings for munis after major catastrophes," says Robert Pariseau, portfolio manager for the (USTEX)USAA Tax Exempt Long-Term bond fund. "Florida suffered through four major storms last year, including Hurricane Ivan, and there were no defaults and no downgrades. The state ended up being upgraded last winter by all the rating agencies."

A municipal, or muni, bond is a debt security issued by a local government to fund capital spending projects such as bridges or sports stadiums. Municipals, as opposed to taxable bonds such as Treasuries and corporates, are exempt from federal taxes and from most state and local taxes, especially if you live in the state where the bond is issued. That is the essence of their attraction.

Munis' favorable tax implications make them a staple in the portfolios of baby boomers close to retirement and a must-have for people in high-income tax brackets, particularly those in states with high state and local taxes, such as New York. And because most muni bonds are insured, their tax-free payouts should be able to withstand most hurricanes no matter where they make landfall.

Winds of Inflation

From Ivan to Katrina to Rita, the winds have been whipping around the Gulf over the past year. The interest rate environment, on the other hand, has remained steady and favorable. Despite the Fed's best efforts to lift long-term rates via 11 straight fed funds rate hikes, the benchmark 10-year Treasury is near 4.2% -- right where it was last year at this time.

One element that has changed since then is the expectation for inflation. Energy prices have jumped, and prices at the pump haven't been helped by hurricane-related refinery shutdowns. Not enhancing matters is the thought of $61 billion in Katrina relief being pumped into an economy already awash in currency from the housing boom.