Simple Steps to Avoid Municipal Bond Scams

Many investors think investing in municipal bonds is safe. But thousands of investors nationwide are learning otherwise, falling prey to unscrupulous brokerage houses and sales people touting “safe” municipal bonds that in fact carry high default risks.

Unfortunately, the elderly or retirees--those who can least afford losses from bond defaults--are among the prime victims. But there are some simple and straightforward steps you can take to avoid being taken.

Aggressive salespeople--often working out of small brokerage firms or so-called boiler room telemarketing operations--are taking advantage of the growing popularity of municipal bonds, which generally pay interest that is exempt from federal tax and often state tax as well. Tax reform made munis one of the few remaining tax shelters, and thus individual investors are flocking to them.

Individuals today account for about three-fourths of the $720 billion invested in municipal bonds. That is a far higher percentage than earlier this decade, when banks and other big institutions were the major buyers of munis.

“Because of the tax benefits, you’ll see people who would never think of putting some money into stocks and bonds putting very substantial amounts into municipal bonds,” says Scott Stapf, director of investor education for the North American Securities Administrators Assn., a group of state securities regulators.

The overwhelming majority of munis are considered sound investments and are bought by mutual funds, big institutions and sophisticated individual investors.

But in recent years, the municipal bond market has become increasingly complex--and risky. It used to be that munis were issued almost entirely in the form of “general obligation” bonds backed by state and local tax revenues. They were used to finance roads, bridges, sewers and other public infrastructure projects.

Now, however, many munis carry names of municipalities but in fact are not backed by those government entities at all. Instead, they are issued by private developers, corporations or other private parties to finance projects ranging from sports arenas to nursing homes to manufacturing facilities. Revenues to pay interest and principal on the bonds comes directly or indirectly from the project involved, rather than from the tax base of the municipality.

Many of these so-called conduit bonds issued prior to 1986 nonetheless enjoyed tax-free status because municipalities--hungry for added jobs and tax revenues--lent their tax-exempt status to these projects. Tax reform in 1986 restricted the ability of municipalities to grant tax-free status, but many private entities have gone ahead and issued munis anyway--except now they may be taxable instead of tax-free.

Whether taxable or tax-free, these bonds must offer higher yields to compensate for their higher risks. But because of their risks, “big, reputable brokerage firms and sophisticated investors won’t touch this stuff,” says C. Richard Lehmann, president of the Bond Investors Assn., a nationwide group based in Miami that tracks bond defaults. That leaves them to be marketed primarily to small investors.

Unfortunately, some salespeople and brokerages specializing in underwriting and selling these bonds--and earning enormous fees and commissions--fail to adequately disclose the risks involved. Some marketers have even been claiming that these bonds are as safe as Treasury bills or bank certificates of deposit--when in fact investors can lose on average as much as 50 cents on the dollar if these bonds default.

For example, a small Jackson, Miss., brokerage firm, Buchanan & Co., recently shut down amid investigations by regulators from at least four states. Investigators found that of 137 bond issues that the firm had underwritten or sold since 1982, at least 64 have defaulted. More than $400 million of bonds were involved in the failures. But investors--mostly elderly and retired--were told these bonds were “99% safe” and “second only to government bonds in security,” investigators say.

Californians have not been major victims of these scams yet, but they nonetheless should be aware of the potential for problems, says G. William McDonald, enforcement chief for the state Department of Corporations, which regulates securities brokerages.

Overall default rates on municipals have been rising nationwide, with some 140 issues with a value of $1.24 billion defaulting in 1987 and a similar number expected for 1988 when all totals are in, says Lehmann of the Bond Investors Assn. The 1987 figure exceeded the total number of bond failures for the entire period between 1972 and 1983, the bond group says. Most of the defaults have been among the conduit bonds issued by private entities.

Compounding the problem is the fact that municipal bonds are far less regulated than stocks or corporate bonds. Little disclosure is required of issuers; for many issues there is no prospectus or statement of any kind laying out pertinent information. Issuers also are not required to file quarterly or annual reports detailing the status of their projects.

“You could be buying a defaulted bond and not even know it,” Lehmann says.

Munis “remain perhaps the single least regulated and most ill-understood investment instrument that is likely to end up in the portfolio of a typical investor,” say the North American Securities Administrators Assn. and the Better Business Bureau in a recent statement.

“It’s very easy even for an investor with some sophistication to make a mistake” investing in munis, says Stapf of the state securities group. He cites the example of the thousands of institutions and individuals who lost money in the record $2.25-billion default of the Washington Public Power Supply System (better known at Whoops).

The problem of inadequate disclosure has caught the eye of the Securities and Exchange Commission. Last year, it proposed new rules that would increase disclosure on municipal bond issues exceeding $10 million in total value.

Unfortunately, however, the riskiest bonds today are issued in blocks that fall below the $10-million threshold. While bond issues exceeding $10 million accounted for 86% of the dollar volume of all bonds issued last year, they accounted for only 1,743 of the 6,972 individual bond financings. It is precisely these smaller issues that are most likely to be promoted to small investors, Stapf says.

The problem of risky bonds being sold to investors without adequate disclosure also extends into popular unit investment trusts, Stapf says. Unit investment trusts, like mutual funds, allow investors to buy a piece of a portfolio of bonds, earning a share of the interest payments.

The majority of these trusts are sound investments and are marketed by reputable firms. But some unscrupulous marketers--earning generous commissions and fees--have been placing high-risk munis into these portfolios in order to boost yields and make them more attractive to investors.

“But they go without telling investors that they are getting riskier and riskier bonds,” Stapf says.

Further, some of these marketers of unit trusts also underwrote the bonds--a potential conflict of interest.

Stapf adds that unit trusts historically are promoted to elderly and retirees. “That magnifies the concern about the potential for damage. The investors are not your typical yuppies.”

How can you avoid being taken in shaky muni bond investments? Here are some suggestions:

- Be wary of any investments pitched over the phone by strangers. Thanks to lenient regulations, Little Rock, Ark., has become a haven for many boiler room operations pitching high-risk munis. But they hawk their wares nationwide.

- Get all performance-related claims in writing from a broker. Act only on those promises that a broker is willing to commit to paper.

- Learn about the basics of a municipal bond before investing. Where will the revenues come from to service the bonds? Where will the proceeds go, and what portion will go to lawyers, financial consultants and developers in hefty fees? What is the financial condition of the issuer, and what are the economic prospects for its project?

Also important to ask: Who is going to make a market in the bond if I need to sell it? Some smaller bond issues are so thinly traded that it may be hard to resell them at a price close to their face or market value.

- If you can’t tolerate losses, consider investing in bonds with insurance to protect against losses through default. Lehmann of the bond investors group says bond insurance will generally cost you about a half a percentage point of yield. “But for most people it’s worth it,” he says.

- Consider investing in municipal bonds through reputable mutual fund companies. Many also offer high-yield municipal bond funds, but you can rely on the professional expertise of the portfolio manager to sort out the junk from the quality.

Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.