(FORTUNE Magazine) – For the individual investor who has, or wants to have, a portfolio including municipal bonds, the Orange County disaster sends three important messages. The first is the importance of diversification, the second is that credit enhancements (like municipal bond insurance) are worth having, and the third is that you should take advantage of disclosure provisions to find out what your mutual fund owns and how creditworthy the bond issuers are.

One of the extraordinary aspects of the unfolding mess is that it did not do more damage to the muni market. After all, Orange County is one of the best-known issuers of tax-exempt bonds, with more than $1.5 billion outstanding. Investors watched in astonishment last month as the county slid from an AA- rating to the lowest rating above default, following a bankruptcy filing only days after announcing that it had suffered big investment losses. And yet remarkably, the $1.3 trillion municipal bond market barely hiccupped.

It avoided the huge selloff many feared could follow the $2 billion Orange County debacle. Traders across the country say that the bankruptcy filing has knocked only five to ten basis points off California municipal bond issues generally (a basis point is one-hundredth of one percent). Even Orange County general obligation bonds have not been trounced the way one might have expected. The day after the bankruptcy filing, those issues dropped about 10% but within days had regained some of their losses.

Why the measured response? In part, the market is waiting to see how the bankruptcy shakes out. Trading in Orange County municipals came to a halt at the height of the crisis. The bid-ask spread, the difference between what potential buyers are bidding and what sellers are demanding, has widened dramatically. According to bond traders, investors simply do not have enough information to gauge how much damage might be done to the county's bonds over the long haul.

Though the county has already defaulted on a $110 million bond issue that was sold to cover pension obligations, a Chapter 9 bankruptcy filing does not necessarily mean it will default on all its issues. As Orange County moves to raise cash by liquidating its ill-fated investment fund and as its property tax payments roll in, the likelihood of another bond default becomes more remote. Also, many of the county's bonds benefit from some form of credit enhancement or insurance and that has helped to prop up prices.

At the start of December, Orange County's 7.875% certificates of participation that mature in 2007 were trading at a price of $107, or $1,070 for each $1,000 of face value. By mid-December the bonds were valued at less than $99, or $990 per $1,000 of face value, by Muller Data Corp. With no known trades after the bankruptcy filing, Muller arrived at its valuation by using the mean of the bid-ask quotes in the market. Most of the county's bonds have suffered similar revaluations as investors sat on the sidelines.

Much of the nail biting among investors has been left to money market funds that invested in short-term notes of Orange County or other Southern California issuers in the county's battered investment pool. Several mutual fund companies rescued their money market funds (among them Franklin Tax-Exempt Money fund, Franklin California Tax-Exempt Money fund, and Putnam Tax-Exempt Money Market fund) by injecting millions of dollars of additional cash in exchange for unsecured Orange County notes of questionable value. The mutual fund companies were afraid of committing the ultimate sin in the money market fund business-allowing net asset value to drop below $1 per share.

The key to investing in municipals, as in any investment, is diversity. Stephen Behnke, a principal of Montgomery Securities, says that if you are a small investor-you have less than $100,000 to put down-your best alternative is a mutual fund. Says he: "Focus on national funds or well-diversified funds of specific states." He adds that before putting money into a fund, investors should find out if it has any exposure to Orange County or other issuers in the county's investment fund.

If you have a large sum to invest in the tax-exempt market and want to do it yourself, bond professionals counsel you to scrutinize the governmental purpose for each bond issue as well as the quality of the issuer's investment portfolio, as painstaking as that task would be. Muni bond insurance is an added source of comfort that adds only a few basis points to the cost of your investment. Insurance or some other form of credit enhancement is especially recommended for those who are not using a mutual fund to invest because they may well be taking on additional risks by not being adequately diversified.

But it isn't absolutely necessary to limit your investing to insured munis or insured muni funds since there are lots of credit-enhanced bonds that don't carry the imprimatur of big insurers like Ambac Indemnity Corp., Financial Guaranty Insurance Co. (FGIC ), or Municipal Bond Investors Assurance Corp. (MBIA). Some munis are backed by bank letters of credit and others have been pre-refunded, which means they are backed by cash and treasuries held in escrow accounts.

William Stevens, managing director of Montgomery Asset Management, and other investment professionals argue that the muni market still offers some great buys, and the yields relative to Treasuries will continue to entice investors. They also point out that few local governments have investment funds as big or as debt-laden as Orange County's, so the likelihood of seeing comparable disasters elsewhere is remote. In most states, municipalities are prohibited from taking on the staggering amount of leverage that paralyzed Orange County.

According to this line of thought, the prospects for a muni market rally in 1995 remain strong. The supply of bond issues continues to dwindle as issuers call billions of dollars in high-interest bonds they sold in the mid-1980s. This means demand will further outpace supply, and that is likely to push up prices. For now, ten-year AAA-rated municipals are yielding 5.85%, which is about 75% of the ten-year Treasury yield and the equivalent of a 8.73% taxable yield for someone in the 33% bracket. The vast majority of them are perfectly safe.

HOW TO GET HIGH YIELDS PLUS GROWTH POTENTIAL If you're searching for a way to grab some of the high yields that have developed in the bond market but also want growth potential, take a look at convertible bonds. They offer some great yields with the added kicker of the option to convert to stock in the issuer at any time for a prearranged price. Convertibles can lessen the impact of interest rate swings because they are debt-equity hybrids. Ultimately, of course, they are most responsive to the fortunes of the company that issues them because their long-term value is based on the underlying equity value and the strength of the credit behind the bonds.

Matthew Avery, senior portfolio manager of the Franklin Income fund, which holds about a billion dollars of convertible bonds, argues that the case for convertibles is especially strong for contrarian investors. Says he: "If you do your homework on a company's fundamentals and invest in the convertibles when the stock is down, it gives you the benefit of current income and later on the equity participation. After all, when you invest in common stock, they don't pay you to wait while things turn around. With convertibles you get paid to wait."

Among Avery's favorite picks are Broadway Stores' 6.25% convertibles that mature in 2000, Genzyme Corp.'s 6.75% convertibles of 2001, and Snyder Oil Corp.'s 7% convertibles of 2001.

Broadway Stores is the former Carter Hawley Hale chain that has come out of bankruptcy and is now controlled by Chicago investor Sam Zell and Chilmark Partners, a buyout firm. Avery likes the new management, though he does worry about the company's floating rate debt in a climate of rising interest rates.

The convertible bonds are now selling at $83, or $830 for each $1,000 of face value. The bonds are currently yielding an enticing 7.53%. The company's common stock, which pays no dividend, trades at about $8, but Avery and the analysts at Franklin Templeton Group see it hitting a 12-month target of $12. Says Avery: "We expect the convertibles to participate in about two-thirds of the upward movement of the common stock."

Avery is a fan of Genzyme Corp.'s convertibles because he says that unlike many other biotech companies, it is well capitalized and has a good supply of new products under development. Genzyme has strong current earnings, and its debt makes up only about 25% of its capitalization. The company's convertibles are currently trading at $83.50 to yield 8%. Franklin analysts are forecasting a 33% growth in income for Genzyme in 1995. They estimate that the per share earnings for 1994 will be $1.40 and that it will rise to about $1.90 for 1995.

Finally, if you think natural gas prices are bound to bounce back soon, you should take a look at Snyder Oil's convertibles. Snyder is a domestic gas exploration and production company with big reserves in Texas and several Western states. Its share price and earnings have been hurt by the drop in natural gas prices over the past year from about $1.92 per thousand cubic feet (mcf) to $1.50. A cold winter in the Northeast would boost prices and probably the price of Snyder's common stock and convertibles as well. Snyder's convertibles are trading for $91.25 and yielding 7.67%, and are not callable before May 1997. Says Avery: "We think the price of gas could go back up to around $1.80, or about where it was a year ago, so we think the prospects for the bonds are great."

- R.D.H.