As municipal bond prices were plunging amid record state and local borrowing, financial advisors were becoming more selective with their retiree client money.

The Center on Budget and Policy Priorities, a Washington, D.C.-based non-partisan research institute, was projecting total state budget shortfalls of $200 billion for 2010. However, it was expecting those shortfalls to shrink to $180 billion and $120 billion in 2011 and 2112, respectively. States also face unfunded pension liabilities of $1 trillion, according to the Pew Research Center, Washington D.C. And defaults on municipal securities tallied $1.6 billion in 2010 through October. Jeff Rose, a Carbondale, Ill.-based financial planner, was keeping his clients well-diversified in municipal bond funds and unit investment trusts. When the muni-bond market plunged in November, he invested clients in closed-end muni-bond funds that sold at a discount to their net asset values.

"I'm really not (concerned about budget deficits and unfunded pension liabilities)," he says. "My advice to clients is to sit tight. Most of the muni-bond investments I utilize are mutual funds or UITs that purchased closed-end funds. So we are greatly diversified across many issuers.

Unfortunately, municipal revenue growth could be hindered for several years, according to a November 2010 survey by RBC Capital Markets, New York. It could take at least five years before state and local government revenues return to pre-crisis levels. "While state and local governments have seen steep declines in revenues, the risk of defaults on bonds issued by these municipalities generally remains well below the similarly rated corporate debt," says Chris Mauro, RBC Capital's director of municipal bond research.

But that information doesn't necessarily console all financial advisors or regulators. At a hearing in New York last month, state insurance regulators expressed concerns about whether the bond ratings reflect current financial data, including government pension and health care liabilities. The municipal bond market also has been under heavy pressure due to oversupply. Issuers were rushing to market before the government-sponsored Build America Bonds program terminates at the end of the 2010.

Steve Paddock, a financial advisor with the East Bay Financial Planning Association, Orinda, Calif., is concerned about municipal issuers' financial problems and the accuracy of bond ratings by Standard & Poor's, Fitch and Moody's.

"There will probably be better opportunities in the future," he says. "The Fed policy of QE2 ("Quantitative Easing 2", which describes the Federal Reserve's purchase of Treasury securities to keep interest rates low and spur the economy) is clearly inflationary and will likely result in increased bond yields and lower prices for already issued bonds. Also, many bond issuers need to take steps to eliminate the red ink before we should get enthusiastic about investing in municipal bonds." 

He recommends that advisor clients consider a dollar-cost averaging approach to building a laddered municipal bond portfolio, emphasizing short maturities of no more than seven to 10 years. He favors general obligation bonds because the issuer normally is obligated to tax all real property to cover principal and interest payments. He also prefers revenue bonds for necessary services.

"Since it appears more likely that interest rates will rise at some point in the future, the portfolio should be built over a period of time, perhaps 12 to 24 months, depending on the investor's situation," he says.