It was easy for many small investors to ignore the credit markets' woes a few months ago, when the crisis was centered in high-risk mortgages owned by big-money investors.
Now, the credit crunch is getting a lot more up-close and personal for investors in markets far afield from dicey home loans -- including municipal and corporate bonds.
As in a bad horror movie, the monster's tentacles are groping around.
The troubles hitting other segments of the credit markets also are pointing up one of the biggest threats to the wobbling U.S. economy: the risk of a protracted jump in long-term interest rates.
Anyone who owns tax-free municipal bonds probably knows the problem there: The alphabet soup of insurance companies (MBIA, FGIC, etc.) that guarantee about half the U.S. muni market also guarantee many bonds backed by sub-prime mortgages. If sub-prime losses sink the insurers, their promises on muni bonds could be worthless.
The fact is, the vast majority of muni bonds don't need insurance, because defaults are rare. But that hasn't stopped some investors from pulling back from the market, which in turn depresses the value of outstanding bonds. That's hurting the share prices of muni bond mutual funds popular with conservative, income-focused investors.
Shareholders of many "closed-end" muni bond funds, in particular, have taken a pounding in recent days. These funds, which trade on major stock exchanges, often use borrowed money to juice their bond bets.
One favorite form of borrowing by the funds is via so-called auction-rate securities. In a nutshell, auction-rate debt is floating-rate debt that resets weekly or monthly.
Borrowers in that market pay low rates as long as there are plenty of lenders to fund the debt. But as skittish brokerages and other investors have curtailed their lending, the auction-rate market has choked up, forcing borrowers to pay steep penalty rates.
Some closed-end fund shareholders, fearing a drag on their returns, have bailed, pulling shares of many of the funds down more than 5% this week.
The picture also has worsened for corporate junk bond mutual funds, another favorite holding of small investors. As the housing and mortgage crisis saps the economy, it raises the risk that highly leveraged companies (i.e., junk borrowers) will have trouble paying their debts. So prices of junk bonds are sinking.
The average junk mutual fund is down 3.4% this year, according to Morningstar Inc.
