"The reasons Kidder, Peabody & Co., Inc. believes the municipal credit cycle hasn't reached bottom, yet, are based on cyclical and structural credit factors," said Neal Attermann, vice president of municipal research at Kidder.

"Municipal finance has outstripped the ability of state and local economies, which is exacerbated by the cyclical problems," Attermann explained. "However, it is the more permanent problems that are cause for concern."

Attermann foresees pressure on local governments because local aid has been cut, in addition to problems surrounding the timely collection of taxes. On the horizon, he notes that local real estate markets, especially in the commercial sector, will continue to suffer.

As a consequence, the local governments may see reassessments that actually lower the value of real estate and further crimp municipal resources.

Additionally, Attermann expects more problems to surface for credits of large cities, with sizable lower income populations, as well as health care credits that will struggle with reimbursement programs.

June Low Water Mark?

R.B. Davidson 3d, vice president at J.P. Morgan Securities Co., explained that his firm has tackled the subject by focussing on essential purpose revenue bonds.

"When general obligation bonds traded at levels close to revenue bond levels, we recommended investors should by G.O. bonds. Now, you must be more selective on a state-by-state basis," Davidson said.

Davidson believes that the darkest days of the recession are past, with the municipal credit cycle reaching its bottom in June this year. "The bad news came in June with the state budget cycle, but investors may face a slightly bumpy road ahead."

John Hallacy, vice president of municipal research at municipal research at Merrill Lynch & Co., explained that "it will probably be after the summer before we'll know for sure" if the worst is behind most municipalities.

Based on some economic indicators, Hallacy feels the municipal credit cycle is close to the bottom.

William Fish, senior vice president and manager of municipal research at Donaldson, Lufkin & Jenrette Securities Corp., said," Even if the national economy is in recovery, state and local governments may not benefiting because of normal lags in tax collections, which may not be received for 45 days" after the end of June.

He noted that information flow has improved since the last recession because of the proliferation of personal computers within municipal government.

Fish is looking for greater confirmation from coincident economic indicators, as opposed to leading indicators, that a recovery has begun in the national economy before predicting if the municipal credit cycle has hit bottom.

Even if the nation's recession does end soon, Fish believes that recovery will vary from state to state, as well as regionally across the nation.

Like Attermann, he noted that a recovery may depend on how much overbuilding was done prior to the recession - which resulted in vacant commercial office buildings - and how regional banks were impacted.

Those states that continue to struggle to balance their budgets or only recently balanced their budgets, may present some opportunities for investors, Fish said. Additionally, he believes increased volume in the housing bond sector could prove attractive to investors.

Frank Trumbour of Loews/CNA believes that even if the recession has ended, investors should be selective in buying municipal bonds.

He noted that each region of the country and each different municipal bond category may not respond the same way.

Opportunities For The Credit Conscious

Overall, the All-American Municipal Analysts feel that today's municipal bond markets offer a wealth of opportunites, both for the institutional investor and retail investor, if they are conscious of credit quality.

George Friedlander, this year's top portfolio strategist, correctly predicted last week's easing of interest rates by the Federal Reserve. He thinks another lowering of rates may be needed before the economy really restarts.

Having correctly assessed the direction of interest rates, Friedlander is recommending that investors purchase essential purpose revenue bonds.

He feels a secular change has taken place in the municipal bond market and that revenue bonds will continue to trade at tighter spreads relative to general obligation bonds.

Donna LoCascio of Donaldson, Lufkin & Jenrette Securities Corp., recommends buying Harris County, Texas, senior lien toll-road bonds.

The issuer recently completed construction of the Sam Houston and Thomas Hardy toll roads under budget. She is the first team All-American Municipal Analyst in the transportation sector.

Glenn Wagner of Morgan Stanley & Co. Inc., top health care analyst, recommends the Hinsdale Hospital in Illinois.

Wagner also recommends that investors pay close attention to their health care holdings.

William Oliver of Prudential Capital Management, first-team G.O. analyst in the special district sector, favors buying California certificates of participation that are supported by "large scale, well planned developments in strong growth areas."

Mark Piliero of Lehmann Brothers Inc., first team analyst in the Special Revenue Bond category, notes that Bridgeport Resource Recovery Bonds may be stronger than many investors might think.

Despite being located in the trouble city of Bridgeport, which has attempted to file for municipal bankruptcy, Piliero's analysis reveals the revenue derived from the municipal waste of Bridgeport actually only accounts for about 10% of total revenues.

Gary Krellenstein of Lehman Brothers suggest picking improving investor owned utility bonds because much of the sector is weak.

"The worst thing that can happen is an investor buys a state general obligation bond, which subsequently downgraded - losing a point or two," according to Smith Barney's Friedlander.

Brighter Prospects

Ultimately, the nation's state, city, and local government officers should find the views of the All-American Municipal Analysts encouraging.

Claire Cohen of Fitch Investors Service said, "I think [municipal G.O. credits] are more resilient than people are giving them credit."

Indeed, Smith Barney's Friedlander believes this is a marvelous time to upgrade portfolios because of today's low credit quality spreads.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.