Pitfalls can cost investors, especially in Oregon, which has a thin resale market

09/01/02

Of all the ways to lose money, from bad poker hands to pork-belly futures, you wouldn't think municipal bonds would rate a mention.

Municipal bonds are the $1.63 trillion backbone of America, providing financing for the nation's schools, water and sewer systems, hospitals and much more. Individuals own the majority of bonds, either directly or through mutual funds.

But municipal bond markets are not inspected or regulated as tightly as stock markets, and critics say the light rein is costing investors millions.

Unwary investors, especially new ones flooding to the municipal market from stricken stock exchanges, may not know they can lose money on municipal bonds -- in a variety of ways.

This prospect concerns people such as Martha Haines, chief of the office of municipal securities at the U.S. Securities and Exchange Commission, who talked to us last week about her concerns and about what her office is doing about public disclosure, investor misperceptions about risk and bond-pricing abuses.

"I confess I worry some about investors who think all municipal bonds are the same," Haines said.

Kevin Olson, a former San Francisco bond trader, worries, too. He thinks the municipal market needs to be more open about pricing, and he campaigns against pricing abuses from his Web site at MunicipalBonds.com.

Olson says the resale market for municipal bonds in Oregon is thinly traded and inefficient, and it "may be worse than the secondary markets for vacation time shares." When consumers don't know the going rate for a bond, they're apt to pay too much or receive too little when they're buying and selling, he said.

Investors generally won't get caught in such a squeeze if they buy bonds when they're first issued by a state, city or its agencies, and then hold them until maturity. Most municipal bond buyers, in fact, hold their bonds, collecting double-tax-free interest until maturity. But potential problems lurk under that scenario, too. A bond issuer could default and stop paying interest or principal.

The granddaddy of all bond defaults, in fact, occurred right in our own back yard: The Washington Public Power Supply System's default on $2.25 billion in bonds 25 years ago is still the biggest in U.S. history.

A smaller default is happening right now in Newport, where the Oregon Coast Aquarium is swimming in debt and trying to restructure payment plans after unauthorized loans arranged by its former director were discovered earlier this summer.

The aquarium hasn't yet missed paying bondholders interest on $14 million in revenue bonds issued to refinance and remodel after its star boarder, Keiko, left for Iceland in 1998. But it has defaulted on $100,000 monthly payments that feed into a fund for future interest payouts.

Enough money is in reserve to pay what's owed when October payments are due and possibly in April, according to Al Gleason, chairman of the aquarium's board and head of PacifiCorp until his retirement in 1994. By then, the board hopes to have a new structure in place to restore finances -- and financial integrity.

Meanwhile, past-due loan payments and reports of financial inconsistencies have led Standard & Poor's to drop its credit rating on the aquarium bonds seven notches, from BB+ to CCC.

Credit agencies such as Standard & Poor's rate municipalities and the bonds they issue. The ratings fall into two categories: investment grade, between AAA and BBB-, and noninvestment grade, or "junk," between BB+ to C.

Investors who want the safest bonds look for AAA ratings; investors willing to take a little risk to increase the interest rate they earn shop for low investment-grade ratings or high "junk" ratings -- from BBB-minus to BB, for example. The aquarium bonds were in that category before they were downgraded.

Speculators who want to take on high risk to earn high interest buy CCC-rated bonds or lower and hope to make money if they recover. That's where the aquarium bonds are now.

The downgrade would be costly for anyone who sells an aquarium bond now. Traders couldn't quote how far the price had dropped late last week because none were trading. But bonds in default can lose half of their value or more overnight.

Another gradient of risk on a municipal bond is the power behind the paper. Some bonds are backed only by the revenues of a project, not by taxpayers. That's why revenue bonds are riskier than so-called general obligation bonds.

The aquarium bonds were issued by the Oregon Health, Housing, Educational and Cultural Facilities Authority on behalf of the aquarium. Their interest payments are backed by the revenues of the aquarium, not by Oregon taxpayers.

If the aquarium bounces back, investors who hold its bonds would receive interest payments and return of principal when the bonds mature. If not, investors could lose part of their money.

Investors who want to avoid the risk of default can buy insured bonds, such as the $118 million in bonds offered in 1998 by Medford's Asante Health Systems to refinance debt and build a hospital in Grants Pass.

Governments or agencies may or may not choose to insure their bonds, because insurance adds to their cost. But insurance is used in health care and nursing home bond issues to attract buyers who otherwise might shy from the greater risk of their revenue bonds.

Insurance can't cover the risks to the bondholders that Olson is concerned about. The former San Francisco bond trader tracks municipal trades and crusades to stop price gouging.

Olson studies the bond prices released daily by the Municipal Securities Rulemaking Board and compiles lists of "red flag" trades when he suspects traders have been greedy by charging buyers too much or not paying sellers enough.

The difference between the selling and buying price, called the spread, is pocketed by the middleman. Oregon bonds rank among his "worst spread" lists along with those of many other states (see accompanying list.)

A four-point spread on a $5,000 bond is $200, but an investor may never know what he's paying, because dealers don't have to disclose what they earn on trades. Bond trades with spreads wider than four points get a red flag from Olson.

The rule-making board doesn't specify an allowable spread. It allows dealers to price bonds however they want, as long as prices are "fair and reasonable."

Olson says the board that oversees the municipal market is a fox guarding the chicken coop because it is made up mostly of bond industry representatives.

But Christopher Taylor, executive director of the board, responds that more pricing information is available today than ever before -- and more is on the way.

Currently, investors can find prices posted on the Web the day after for frequently traded bonds. A report of all bond trades is available in a week, and a final report comes out a month after the trade.

By November, more next-day information will be available. And "sometime in 2004," Taylor says, there will be 15-minute price reporting akin to what the stock markets have today.

Olson makes too much of price spreads, Taylor says. Of the average 29,000 municipal bond trades in a day, Olson finds 30 to 40 to flag as questionable. Taylor says computer input error and misreporting by bond traders often is the culprit in spreads appearing to be excessive.

That happened in Linn Benton Community College bond trades Olson flagged as the 13th worst spread among bond trades in 2001. In reports to the rule-making board, someone appeared to have bought the bonds for 64 cents on the dollar and sold them for 92 cents of the dollar.

"Something's wacko," said Dave Taylor, vice president of Seattle Northwest Securities, the bond firm that advised the college on the issue. In fact, the firm made less than 1 percentage point on the deal, not 28 points. An error occurred in reporting the bond issue that financed construction of the community college's centers in Lebanon and Corvallis.

Other bond spreads can't be attributed to error, however, Olson says. And that's why regulators need to do more and why investors need to be on guard. Julie Tripp: 503-221-8208; julietripp@news.oregonian.com