"If 2011 could be described as the Year of Fear" after numerous muni bond defaults, says TIAA-CREF's Barnet Sherman, "then 2012 is the Year of the Yield." Seeking yield, that is. Optimistic or not, the notion of government bonds providing a no-brainer income guarantee-that investors can set it and forget it-are gone. "You have to do your homework."

He's got a lot more homework now. Although muni bonds have been around since 1945, when a trifling $20 billion of municipal debt was outstanding, today's market is nearly $4 trillion, and its dangers are multifaceted. Even the tax exempt status of munis may be at risk. The only certainty is uncertainty.

Data from Concord, Mass.-based Municipal Market Advisers, a research and advisory firm, show a rolling 12-month total of 100 municipal defaults for the period ending July 26, 2012, a drop of 50% from the previous period, and the greatest decline since 2009. That's an improvement (if small comfort for investors in those particular munis). But there are still warning signals as certain cities face economic difficulty. Within three weeks in June, three California cities authorized filing for bankruptcy. Also this summer, debt obligations forced Scranton, Pa., to cut payroll-slashing fire and police compensation to $7.25 an hour. The city of San Bernardino, Calif., borrowed against its future property taxes-but then was hit with property foreclosures. False filings showed the city had been in the black for 16 years, when it was actually in the red for 13, according to the city attorney.

The deception typifies the types of risks I found two years ago after reviewing the procedures used by Moody's Investors Service. An October 2009 paper by Moody's described its rating process and a series of weightings it used. The yawning gaps between the assumptions that supported weightings and real-world municipal practice left plenty of room for sloppiness and fraud to slip through the agency's analysis. Moody's, for example, favored states with oversight boards, which it believed "ensured consistent standards of financial integrity." But of the two local finance boards the agency cited, in North Carolina and New Jersey, the former's finance board was peppered with political appointees and New Jersey's commissioner was forced from office in 2009 by an FBI raid. Also, Moody's continued to favor munis with higher numbers of new construction permits, according to the October 2009 paper, even though it was widely known by then that overbuilding had helped collapse the economy in 2008.

Not surprisingly, municipal fund managers take ratings under advisement, but rely on their own research. At the same time, the muni market is facing difficult economic realities and beefed up regulatory oversight. Expected prohibitions in the Volcker Rule, for instance, influenced a decision by Citigroup Global Markets to shelve its plans to trade municipal bonds in tranches (much the same way it did mortgages).

"The muni tranches market wasn't there for the product," says Mikhail Foux, a Citi researcher and analyst. But the bank did succeed in getting the form used in municipal credit default swaps (MCDS) standardized to match corporate insurance contracts. That uniformity allows contracts to unwind easier, making the insurance more attractive, which could prove positive for higher-risk bonds from states like California.

Also promising is that for the first time since 1996, local governments are paying back more debt than they're taking on. In 2011, U.S. states and cities paid back $59.5 billion more debt than they incurred annually for the first time in 15 years. The five-quarter trend continued with a debt pay-down of $54.1 billion in the first quarter of 2012 alone, according to the Federal Reserve's first-quarter 2012 "Flow of Funds" report. The payoffs shrank the municipal bond market by $11.3 billion, as of the first quarter 2012, to $3.73 trillion from the previous quarter's $3.74 trillion.

A large part of the issuance now is being used to refinance government debt at the lower interest rates. As of this June, year-to-date refundings are up 155%, while new borrowings by municipalities have risen only 14%, according to Citi Investment Research & Analysis, a division of Citigroup Global Markets. "The massive amount of refunding supply is, to a significant degree, creating its own demand," says Foux, one of three strategists who author Citi's Municipal Market Comment.

Because demand has trumped supply, borrowing rates have dropped from more than 5% to about 2%, Foux says. Lower borrowing rates and extended terms are good for municipalities' operating budgets. But early payments create problems for investors hoping to live off the yields on their bonds. At lower rates, the consumer-dominated munis are threatened by what Foux calls "individual investor rate shock," where consumers decide they might as well go to lower-risk Treasurys for the same return.

Some muni funds have fared well, such as the Tax-Exempt Bond Retail Fund (TIXRX) run by TIAA-CREF, the Charlotte, N.C.-based retirement specialist. With $351 million in assets, the fund had a one-year total return of 9.76%, as of July 27, and was up nearly 12% in 2011, despite the trend in early payoffs. This is because the fund holds "many bonds that have not reached their call period or aren't callable," says Sherman, the fund's manager and TIAA-CREF's director of credit research.

Still, declining yields are a problem for many retirees. In 2002, a 10-year "AAA" muni bond offered an annual yield of 4%, which means a $1 million investment once produced a tidy income of $40,000 per year. "Fast-forward to today, and the yield on a similar high-quality bond is about 1.90% or $19,000 a year," says Sherman. "The investor is asking: Where am I going to find yield?"

The quest for yield can be measured in the flood of cash into high-yield bonds at the rate of $210 million a week, notes James T. Colby III, Van Eck Global's chief municipal strategist. But it is a little worrying that, according to investment bank underwriter Siebert Brandford Shank & Co., five of the six states catching the most fund flows in June were some of the largest debtors struggling with unfunded obligations: New York, New Jersey, California, Florida and Illinois. (In 2010, New Jersey was the first state to be sued by the SEC for hiding its true financial condition from bond investors.) On May 31, Colby wrote in his weekly "Muni Nation" column, somewhat tongue-in-cheek: "End of May, don't go away," a twist on the popular equity market advice, "Sell in May and go away." It was a subtle suggestion that you shouldn't take your eye off your muni investments.

"There's going to be still good demand for munis and the relative value that munis represent versus other asset classes," says Colby, who manages five Van Eck muni ETFs. They look good, he says, next to high-volatility equities and low-return money market funds. "The question is, what do you do for yield, where do you go?" The Market Vectors High-Yield Muni ETF he manages (HYD) had a 12-month yield to date of 5.21% as of July 30, according to Morningstar.

Municipal revenues have been depressed by falling real estate values, especially in California, Arizona, Nevada and Florida, notes Citi's Foux. "But real estate is stabilizing and is a much smaller part of the economy anyway," he says. "On the local level, there may be some credit events, distress situations such as Scranton's parking authority, Detroit and Providence."
Foux's examples are an eye-opener for investors considering muni revenue bonds, which are generally regarded as less risky. The Scranton city council on May 31 refused to transfer $940,000 to the parking authority to help it make a bond payment due June 1. The city reversed itself the following week and the bond payment was made, but not before Bank of New York Mellon, the bond's trustee, threatened to take over the authority's garages. According to news reports, the transfer satisfied the immediate problem, but the authority appears to be limping along payment to payment.

Since revenue bonds generate their own bond payments, such as parking fees in this instance, they are often preferred over general obligation (GO) bonds, which rely on government budgets. Bond buyers also prefer issuers that place their bond debt outside of tax spending caps.

Despite revenue flow, the Detroit Water and Sewerage Department is having problems bringing a $500 million debt issue to market in the midst of a dispute with the state that threatens to bankrupt the city. The risk could push yields up if the bond issue, whose proceeds are needed to unwind numerous derivative instruments hedging $1.4 billion in sewer debt, gets to market.

All three major muni bond rating agencies downgraded Providence, R.I.'s GO and revenue-related bonds this spring to just above junk bond status. An S&P analyst called the city's budget "structurally imbalanced."

In late June, Moody's slashed the ratings on $11.6 billion in California tax-allocation bonds to junk, lowering bonds rated "Baa3" or higher to "Ba1." These bonds had been tied to the state's redevelopment agencies, known as RDAs, that partnered with developers for projects in troubled areas and used property tax money. These agencies were dissolved by the state, and Moody's cited its concerns about whether RDA bondholders would be paid on time while the agencies were being unwound.

But on the whole, muni bond defenders, who have only grown in ferocity after bank analyst Meredith Whitney made her dire 2010 forecast of 50 to 100 municipal defaults, insist California is still an anomaly. Foux also asserts that, unlike some cities, state governments have seen their tax revenues improve overall. And U.S. Census figures for 2011 support him, showing states collected $56 billion in taxes last year, an increase of 9.7%-greater than the 9.2% rise in corporate tax revenue.
(For the record, Whitney meant municipal "default" to include cutbacks in public employee rolls and pension promises. As previously stated, first-time defaults have come down, but 100 were filed for the year ended July 26, 2012.)

 As for the flow of tax money into states, it must be viewed against each state's outward flow for ever-expanding retirement payments and health benefits. The latest analysis by the Pew Center on the states, called "The Widening Gap," underscores that not all states are recovering at the same pace, another reason to scrutinize each issuer. Pew found that the gap between states' assets and their obligations for public sector retirement benefits widened again in 2010, the most recent year available, to $1.38 trillion, up nearly 9% from 2009. In 2000, more than half the states were 100% funded, but by 2010, 34 states had fallen below Pew's 80% cutoff for a healthy pension fund. Only Wisconsin was fully funded. And only 75% of states' pension liabilities were funded. The Pew report singled out Connecticut, Illinois, Kentucky and Rhode Island as "the worst," as all were under 55% funded in 2010. North Carolina, South Dakota, Washington and Wisconsin were the only states funded 95% or better. Note, Pew said that between 2009 and 2011 some 43 states enacted benefits cuts. Those made in 2010 and 2011 were not captured in its report, such as Rhode Island, where cuts in 2011 effectively reduced its unfunded liability by an estimated $3 billion.

Retiree health-care obligations, which usually are not budgeted in advance, paint a bleaker picture. States should have set aside nearly $51 billion to pay for these expenses in 2010, according to Pew, but instead they contributed just over $17 billion, or 34% of that. Only seven states funded 25% or more of their obligations: Alaska, North Dakota, Ohio, Oregon, Virginia, Wisconsin and Arizona (the last state made the only full contribution).

In a report released July 17, the State Budget Crisis Task Force, co-chaired by former Federal Reserve Board Chair Paul A. Volcker, found that three states out of the six it studied, California, Illinois and New Jersey, accounted for more than half (58%) of the annual required contribution shortfall from 2007 through 2010. The six, which also included New York, Texas and Virginia, had underpaid their contributions by more than $50 billion during those five years. To fund past promises and current benefits in the future, the group projects, the state and local governments would have to increase spending at least $25 billion annually.

A bright spot on the horizon is the progress being made in municipal oversight, which Colby attributes partly to pressure from professional investors over the past 10 years, and the capture and sharing of online data by the Municipal Securities Rulemaking Board, designated by the Securities and Exchange Commission in 2008 to receive municipal finance documents. (The board maintains the Electronic Municipal Market Access, or EMMA, Web site, where the public can view documents.)
Also, two of five new offices within the SEC, in compliance with the Dodd-Frank Act, will address municipal finances. The Office of Credit Ratings (OCR) examines and monitors the nine registered nationally recognized statistical rating companies (including S&P, Moody's and Fitch). The Office of Municipal Securities, which had been delayed for funding reasons, is going ahead under Commissioner Elisse B. Walter, and it is charged, among other things, with adopting permanent rules for the registration of municipal advisors.

The OCR issued its first annual report on September 30, 2011, which singled out two smaller rating agencies for failing to follow their policies and procedures affecting the rating of asset-backed securities. Unfortunately, according to an SEC spokesperson, the OCR will not be identifying rating agencies by name in its reports. Overall, the OCR praised the agencies for responding to the office's suggestions.

Outside of government, securities data provider Morningstar plans to launch municipal market credit information and services for registered reps, asset managers, banks and insurance firms.

But even though investors will have more access to data, it won't always be fresh. Municipalities are sluggish in getting their documents filed with the Municipal Securities Rulemaking Board, says Richard Ciccarone, chief research officer for Oak Brook, Ill.-based McDonnell Investment Management, which manages more than $13 billion in assets, largely muni bond portfolios, for institutions and high-net-worth clients. "There's just greater transparency provided in fresh documents, which helps put the appropriate price on bonds," says Ciccarone, who previously co-headed fixed income at Van Kampen Investments Inc. "At times, municipal pension information can lag by a year."

The pension data, he says, can double a municipality's net direct and total liabilities outstanding. Yet, "There's no government penalty for cities that fail to file, even on EMMA," notes Ciccarone, who is also CEO of bond research firm Merritt Research Services, in Hiawatha, Iowa, which provides an ongoing database of current municipal credit information to subscribers. The Virgin Islands can take up to two years with its information. "The best among states and territories in the past five years is New York state, which filed inside of 120 days," he says. Congress can't penalize the states because of the Tower Amendment, which prohibits the federal regulation of municipal securities. But the SEC is looking at how to shorten the reporting times, Ciccarone adds. (The commission released a 165-page report on July 31 calling for major reforms in the municipal bond market.)

A positive note on the disputed tax-free status of munis: Even if the bipartisan "Super Committee," charged by Congress with recommending cuts to the federal budget, fails to act, thus triggering automatic cuts at year's end, they won't strip munis' tax-exempt status, which costs the federal government billions annually, says Colby. "For the last couple of decades, it's been challenged at points in time." Without success ... so far.