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Over the past month, I've been getting a lot of questions from clients regarding specific credit events in the municipal bond market. Recent credit downgrades and bankruptcies clearly have some muni investors on edge.

The past few months have certainly been a bit of a roller coaster ride for the municipal market. In December, I wrote about the fear of a potential loss of the tax-exempt status of municipal bonds, which drove a sell-off in the muni market. After the Fiscal Cliff was resolved and it was clear munis would remain exempt from federal taxes, investors flocked back to the sector and bond prices rose. Then in March we saw another pullback, potentially driven by high net worth investors selling their munis and using the proceeds to pay 2012 tax bills.

On top of all of this is news about the credit worthiness of specific municipal issuers. Below are some of the most talked about names and what recent developments may mean for muni investors.

Stockton, California. After filing for bankruptcy protection in June 2012, the city received court approval to go ahead with Chapter 9 bankruptcy proceedings. Stockton was one of three California cities to seek bankruptcy protection last year, including Mammoth Lakes and San Bernardino. The combination of falling real estate values and too much public sector spending, including pension obligations, took a toll on the cities' finances. Today the impact of these events is already priced into their outstanding bonds.

Puerto Rico. Traditionally, investors have added Puerto Rican bonds to both national and state-specific portfolios because they are exempt from U.S. federal and state income taxes (83% of single state mutual funds have exposure to Puerto Rico). Currently, the Commonwealth of Puerto Rico faces underfunded public employee pension obligations and a slowing economy, but the administration is reviewing steps to reform the pension system and tax policy. Puerto Rico was downgraded to Baa3 by Moody's in December and BBB- by Fitch and Standard & Poor's in March. This puts Puerto Rico at the lower end of the investment grade credit scale. Yields on Puerto Rico's bonds increased in response to the downgrade. If Puerto Rico falls below investment grade and into high-yield territory, we could see bond prices decline as some investors sell their positions.

State of Illinois. The state of Illinois was recently downgraded to A- from A by Standard & Poor's as pension obligations for public employees weighed on the state's finances. The state legislature is currently considering proposals to deal with the shortfall. Illinois is still able to issue debt and experienced high levels of demand for recent bond offerings.

State of California. Finally some good news -- the state recently received a credit rating upgrade by Standard & Poor's to A from A- following news that its budget would have a surplus this year. The combination of spending cuts and higher state income tax rates resulted in a favorable outcome for creditors. Bonds issued by the state traded at tighter spreads following the news.

So how should a muni investor think about these events? Well, if you're concerned about downgrades and bankruptcies, one solution is to invest in a high-quality, diversified municipal bond fund. For example, all of the iShares municipal bond ETFs hold only investment grade bonds, which basically means they do the filtering for you. If an issuer gets downgraded to below investment grade (lower than BBB-/Baa3), the bond will be removed from the fund’s index at month-end and rebalanced out of the fund. iShares municipal bond ETFs also are well diversified in terms of issuer type and geography.

Even with these events in the municipal bond market, we still favor the sector. The combination of higher tax rates and lower levels of supply should be supportive of prices of municipal bonds this year. And relative to other types of debt, municipal bond after-tax yields still look attractive relative to similar credit quality corporate debt.

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Disclaimer: Bonds and bond funds will decrease in value as interest rates rise.

Source: From Stockton To Puerto Rico: What's Driving The Muni Market?