Also See:
* How to Make Sure Your Bonds Are Safe
* The New Bond Bubble

It looked like the closest thing you could get to a sure bet even in a city full of one-armed bandits. The state of Nevada planned to build a sleek, automated monorail that would ferry millions of tourists up and down the famed Las Vegas Strip. And they were funding it by selling more than $600 million in municipal bonds some of them paying a hefty 7.5 percent in interest. With AAA ratings, they were the very definition of safe muni bonds.

But something funny happened on the way to the casino. Fewer tourists came to Vegas, and those who did weren t up for a train ride; the monorail brought in far less revenue than expected. The nonprofit monorail agency filed for bankruptcy-court protection earlier this year. As for investors, not only have their interest payments dried up the project s bankruptcy attorney confirms that it won t make its next payment, on July 1 but they could lose almost all of their principal. The stranded buyers include top fund companies like New York based DWS Investments. Its $6 million stake was a tiny fraction of its $1.6 billion DWS Scudder Strategic High Yield Tax Free fund, but manager Phil Condon still seems flummoxed. After all, such a disaster in a highly-rated municipal bond is almost unheard of. We re not perfect, Condon says.

Neither, it turns out, are muni bonds. A once-stable class of investments built on the nation s roads, sewers and schools is beginning to look as shaky as, well, many of the nation s roads, sewers and schools. In recent months, of course, investors have seen apocalyptic headlines about all kinds of government-issued bonds starting with those from Iceland and Greece, foreign nations stuck with tremendous debt and nowhere near the revenue to pay it off. With California s government issuing IOUs and other states and cities slashing services, there s been plenty of reason for investors to feel nervous about the $3 trillion, U.S. municipal bond market. When they get anxious enough to ask their brokers about their Puerto Rico-sewer and Pennsylvania-turnpike bonds, however, they generally hear the same answer: It s too soon to worry.

“ DEFAULTED: Las Vegas's $600 million monorail bonds.”

But investors are starting to see signs of deeper problems hairline fractures in the muni market s foundation. With the real estate crash and high unemployment robbing cities and towns of tax revenue, more municipalities are being forced to renege on their debts. Since last July, 201 municipal bond issuers have missed interest payments on some $6 billion worth of bonds, or an average of about one every other day. That s up from 162 in 2008, and a hefty increase from the 31 that did in all of 2007. To be sure, most of these busted bonds are not of the caliber that most Main Street investors buy. But the tremors are enough to inspire jitters among money pros. Already, sober-minded bond analysts and even a few state officials are beginning to join the fringe doomsayers in warning that there s potential for a municipal bond collapse. A small but growing number of financial advisers are uneasy too, telling clients to pull back a bit.

Whether those warnings are being heeded, though, is unclear. With their attractive and often tax-free yields, muni bonds have long been a draw for risk-averse investors, particularly retirees looking for a steady and reliable payment. Given how meager savings-account interest remains, it s not surprising that investors are still pouring an average of nearly $800 million in new money into munis each week, on top of the record $70 billion they put in last year. What s more, investors would need a keen eye to know the problem is escalating. After all, a missed interest payment on a bond in Beaumont, Texas, barely gets mentioned in Beaumont, let alone on CNBC. Mutual fund shareholders, meanwhile, would have an even harder time noticing a muni crisis at first. The impact of any single Vegas-style flameout is muted in a fund holding hundreds of bonds.

But pile on more defaults or other troubles, say skeptics, and prices in the whole category could plummet. If that happens, says Bob Froehlich, senior managing director of The Hartford, an insurer with a municipal bond portfolio of $12 billion, bond owners will have two choices: tie up their money for years by holding the bond to maturity or sell at a loss. A lot of investors were naive, thinking, It s so safe, nothing can happen to it, Froehlich says. It s on-the-job training for a lot of investors.

For today s generation of advisers, witnessing a municipal bond default is on par with seeing a living woolly mammoth. From 1974 to 2009, the default rate on bonds rated investment grade by major credit agencies was 0.3 percent. (Corporate bonds defaulted five times as often over the same time frame, according to Moody s Investors Service.) For the most part, municipal credit is very sound, says Jim Murphy, who oversees a $1.8 billion tax-free high-yield bond fund at T. Rowe Price. Bond investors often attach a stigma to a town that defaults on municipal debt, which means that if it ever wants to raise money again, doing so will be much more difficult and expensive.

But as the financial crisis proved to many investors, investment-grade ratings mean bupkes if revenue dries up which is exactly what began to happen to the world of munis as the market crash and recession took their toll. The stories behind high-rated bonds that defaulted could fill a book, beginning with a $70 million municipal bond that the state of Illinois issued in 2004 to build student housing near DePaul University on the North Side of Chicago. The building, called Loft-Right, boasted a great location and furnishings from famed executive-chair maker Herman Miller, and students initially flocked there. But building flaws quickly led residents to dub it the Loft-Wrong, as they complained of noise, a lack of closet space and leaky windows. It was pretty third world and chaotic, says Chase Teschendorf, a DePaul student who lived in the building. By 2007 nearly half the rooms were vacant and rental income plummeted. The building s owner missed a bond payment in late 2008 and another two payments last year, leaving investors without almost $5 million in money they re owed. It s unclear if they will get any of it. A spokesperson for DePaul says the university has no ownership interest in the dorm, now called 1237West, and no responsibility for its bonds. Neither the owner, MJH Education Assistance Illinois, nor the Illinois Finance Authority, which issued the bonds, would comment.

It s easy to dismiss failures like Loft-Right and the Vegas monorail as flukes, investments that critics say were undermined by poor execution (or were questionable ideas to begin with). But far more bonds are threatened by the shaky condition of state and local governments, which analysts fear could turn the market s cracks into bigger fissures. There s a natural lag between economic stress and stress realized in municipal finances, says Mitchell Savader, CEO of Savader Asset Advisors, a municipal bond research firm in New York City. Towns, schools and agencies issued thousands of bonds over the past decade whose ability to keep paying investors was dependent on real estate prices rising, the economy growing or both. With no quick turnaround in sight, these governments will have to slash spending, and maybe raise taxes, to pay their debts. That is, unless they simply leave investors hanging.

“ AFTER RENTAL income plummeted at a student housing project near DePaul University in Chicago, $70 million in bonds went into default.”

In Beaumont, an oil town two hours east of Houston, the government decided in 2007 to increase the stock of affordable housing. The city issued $5 million worth of 30-year bonds to pay for the renovation of 150 apartments in southern Beaumont, a part of town hit hard by Hurricane Rita. The project had a simple goal: spruce up the neighborhood by building a playground, adding laundry rooms and throwing in other little touches. It looked viable at the time, says Lance Fox, a lawyer who worked with the city on the bond issue. But the economic growth never came, and the developer didn t finish the project. Today the site is a vandalized, largely empty mess, and when a tenant moves out, there isn t even enough money to clean or repaint the apartment for a new occupant, according to U.S. Bank, the trustee for the bond. The developer, who is responsible for repaying the bond, has missed three interest payments in the past year. What can an investor reap by selling? A paltry 23 cents on the dollar.

For bond watchers, Beaumont s tale is particularly troubling because it represents a kind of investment that s increasingly common: the uninsured bond. Investors used to derive some confidence from the fact that their munis were backed by insurance. The Vegas monorail bonds, for example, were attractive to investors, in part because many of the bonds had insurance. The insurance, however, became useless after Ambac, the insurer, ran into its own problems writing policies on other types of debt. The insurer stopped covering claims on the monorail bonds this spring. Under a plan proposed by Ambac s regulator, the Wisconsin Insurance Commissioner, investors in the monorail s insured bonds might get only 25 cents on the dollar in cash for claims (Ambac referred requests for comment to the regulator). Indeed, the financial crisis has claimed its share of insurance companies, and many will no longer insure even high-rated bonds. Five years ago about 55 percent of muni bonds were issued with insurance; today only 11 percent are, according to Thomson Reuters.

With that kind of uncertainty, more advisers are saying no. Drew Tignanelli, president of the Financial Consulate in Hunt Valley, Md., once relied on munis as a staple of his clients portfolios, buying state bonds from Maryland and Florida. But during the financial crisis, as state budget deficits widened, he sold them off; now he s avoiding munis altogether. The states and municipalities are getting hit, he says. We never felt it was as dangerous as it is today. Other investors share his unease. Philip Greenspun, a Cambridge, Mass., computer scientist who blogs regularly about finance, says he owns munis but only from foreign countries. Here in the U.S., he says, I don t think the extra yield over a Treasury bond is worth the risk, quite honestly.

It doesn t take a default for a municipal bond to lose value. If a city or town faces financial problems, potential buyers won t pay as much for its debt. Some bonds of financially strapped areas of Michigan now trade around 70 cents on the dollar. Almost 13 percent of municipal bonds currently active are trading at less than their face value, according to Barclays up from 7 percent before the recession. Rising interest rates, which many commentators believe are on the horizon, can also hurt the value of muni bonds. Falling prices aren t a huge problem for people who hold their bonds until they mature. But someone who needs to sell a bond can take an ugly loss if prices stay depressed. And widespread falling prices could actually harm more investors than the defaults themselves by depressing prices for muni funds, which are held by more little-guy investors.

To be sure, almost no one is predicting a total municipal bond collapse. Savader, one of the more pessimistic analysts, says there might be 100 more defaults in 2010, out of some 60,000 bonds currently active. But even if the crisis doesn t spread, it remains bigger than it s been in decades. Even investors who still have faith in munis are waiting for the next shoe to drop. Carolyn Walder, a financial planner in Alexandria, Va., has clients who own bonds tied to the $611 million baseball stadium that opened in Washington, D.C., two years ago. The Nationals, the team that uses the park, has struggled. That, along with a weak economy, could mean disappointing sales of tickets, souvenirs and hot dogs all of which are supposed to cover payments to bondholders. Both the team and the district government say the park is generating more than enough money to cover the bonds. Still, Walder is watching carefully. I don t think the district would default, she says. But in this economy, who knows?