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4 Strategies for Nervous Muni Investors

BOSTON (TheStreet) -- There was no immediate impact on the municipal bond market decision today when Standard & Poor's dropped the United State's long-term credit outlook to "negative" from "stable."

It adds to debate over the federal deficit, though, increasing the prospect of rising interest rates and escalated budget cuts. Investors in municipal bonds may have good reason to fear national woes becoming state problems.

Get as much of your money upfront as you can, is the advice of one financial adviser for those collecting on a public pension amid a climate of political battles and the threat of state defaults.

Unlike the federal government, states, counties, cities and towns can't just "print money" to get out of trouble. If deficit reduction demands measurably impede the flow of federal money for education, construction projects, public transportation and the like, it would be bad news indeed for financial train wrecks of states such as California, Illinois, New Jersey and Nevada, tipping them closer to default and hurting investors and those relying on public pensions -- a second cause for alarm after the political fights that began in Wisconsin in February.

Jonathan Bergman, vice president of Palisades Hudson Financial Group, a Scarsdale, N.Y., firm with $1 billion under management, suggests four strategies to consider, in particular for those whose portfolio or retirement plan has an exposure to municipal bonds:

Sell individual municipal bonds and reinvest the proceeds in a multistate muni bond fund
With more muni bonds issued by cities and towns than states, a state default could drag down their value because municipalities depend on state aid, which would be slashed in a crisis. Bergman says investing in a national municipal bond fund will reduce the risk posed by a single state defaulting.

"Generally investors perceive the risk in munis as low, and now they are starting to think maybe there is some risk here," he says, adding that these are "no longer a widows-and-orphans investment."

"The cleanest, simplest easiest thing for individual investors to do is no longer hold single-state municipal bonds," he says. "It is worth paying a bit more in state income tax for that protection. It completely diversifies your holdings and reduces your risk."

Bergman compares being heavily into one state's or municipality's bonds as akin to having a portfolio top-heavy with your own company's stocks.

"Not only are you exposed to the stock price and any failure of the business but, of course, it is your employer, so you are exposed to it through your job," he says, "If you live in New York and you own New York state bonds, not only are you subject to the state's economy, you are also putting that in your portfolio. Your house, probably one of the larger assets in your portfolio, is dependent on the state's economy, and now your municipal bond portfolio is tied to that too. I think the easiest, simplest thing is to diversify your municipal bond portfolio."

Public employees, who have their pensions and other benefits tied to the financial health of the state or municipality, "most certainly shouldn't also own state municipal bonds of the states from which they retired," he says.

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