The hidden risks in bonds

What you don't know - and can't know - about munis can hurt you, says Fortune's Bethany McLean.

By Bethany McLean, Fortune editor-at-large

(Fortune Magazine) -- Municipal bonds, used to fund everything from bridges to hospitals, are sold as stodgy investments for moms and pops. But in a speech last July, SEC chairman Christopher Cox delivered a stark warning: Muni bond investors might think they "can rest assured that their interests are fully protected by the same high standards that operate everywhere else in the U.S. capital markets," Cox said. "Not even close."

One of Cox's predecessors, Arthur Levitt, called reforming muni bonds his "obsession." Even now, a lack of timely, easily accessible disclosure is a big problem, especially since skeptics say that the industry's big players - rating agencies, mutual funds, and bond insurers - aren't always effective watchdogs.

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Cox's concern is that individuals, who he said own 36% of the $2.5 trillion in muni bonds outstanding directly and another chunk through mutual funds, pay the price when there's a blowup. (And the blowups always seem to be big.)

To see how scarce information can be, look at the Pennsylvania hospital chain West Penn Allegheny Health System, which in mid-May sold $752 million of bonds - the largest junk-bond health-care muni bond offering ever.

The chain has a history of financial trouble. It was created in 2000 via the merger of Pittsburgh hospitals that had belonged to the Allegheny Health, Education, and Research Foundation, which declared bankruptcy in 1998, and another Pittsburgh-based chain called West Penn.

The new West Penn used the May offering to refinance roughly $600 million of debt, most of which carried an average interest rate of more than 9%, with $752 million of debt carrying an average interest rate of just over 5%. West Penn also weakened the protections for bondholders.

Most notably, while West Penn previously had to have enough cash on hand at the end of June and December to cover 50 days of operating expenses, the new bonds require just 35 days of cash.

West Penn was able to get such a great deal partly because last spring the credit markets made almost anything possible. But management has also said it has pulled off a "dramatic" and "phenomenal" turnaround.

Rating agency Fitch, which upgraded West Penn's credit, cited its "significant" progress as well as a near-term reduction in its interest expense (even though it now must pay back way more debt) as reasons for optimism.

But if your fund owns West Penn's bonds, it's hard to check out the numbers in the way you might check out IBM's financials, if your mutual fund owned a big slug of that stock. As Cox pointed out, there is no free national repository for municipal documents like the one the SEC's EDGAR provides for corporate documents. While big bondholders may receive financials directly from an issuer, you would have to do some serious digging - and some serious waiting.

For West Penn, the most recent financials available are for the nine months that ended in March. The numbers for the fiscal year ended in June aren't out yet. If you were to locate those nine-month results - one source would be Bloomberg, although you would have had to wait until early August - you'd see that West Penn's recent numbers are anything but phenomenal. Its operations lost $8.5 million over that nine-month period. By March, West Penn had cash to cover just 54.2 days of expenses - and without a one-time prepayment for future services of $35 million, cash would have fallen to below 50 days.

What you'd probably never learn is that even those numbers don't tell the whole story. Last fall, in a presentation to MBIA - which insured a chunk of West Penn's old debt - management stressed the dire need to upgrade the facilities. (It may have been trying to persuade MBIA to help out with new financing, which MBIA did not do.)

West Penn also forecast EBITDA of $126 million annually for the next five fiscal years. Even in that case, it said there was a $135 million gap between the necessary capital expenditures and what it could afford to spend. The new debt will help - but in the first nine months of the year, EBITDA was just $74 million, or 59% of the projected $126 million. (West Penn blames sagging profits on issues in anesthesiology and says, "We feel we have the tools in place for disclosure should information on our organization be required.")

In July, West Penn's CEO and another executive abruptly quit. West Penn insists this was "totally unrelated to finances," and cites differences over "strategic direction," although there had never been any hint of that previously. Is this all? It's hard to know. And that's the dangerous thing about muni bonds.  Top of page