Charles Schwab analysts advise muni investors to avoid debt from Chicago, Michigan local governments, and tobacco bonds.

CHICAGO — Charles Schwab is advising investors to be wary of Michigan local general obligation bonds and Chicago debt as "pockets of risk" in an otherwise improving municipal market, the brokerage firm said in comment released Friday.

Investors should also avoid tobacco settlement bonds, the firm said.

The comment purposely excluded discussions of Puerto Rico or Detroit, because "the problems facing these two areas have been covered extensively, including by us," wrote authors Cooper Howard and Rob Williams, fixed-income experts at the firm.

Credit conditions in the muni market overall are improving, Schwab said. But there are at least three areas of risk: Michigan local general obligation bonds, Chicago debt, and tobacco settlement bonds.

The comment notes that bankrupt Detroit has reached an agreement with its unlimited-tax general obligation bondholders that calls for a recovery of roughly 74%. But no settlement has yet been reached with the city's limited-tax GO holders, and the city's current proposal calls for a recovery of between 10% and 13%. That treatment would be on par with some of the city's lowest-ranking unsecured creditors, Schwab says.

"This concerns us because if limited-tax GOs are allowed to be significantly impaired, it could pave the way for troubled Michigan limited-tax GO issuers to pursue a similar path in the future," they wrote. "Therefore, we believe additional caution is warranted when it comes to limited-tax GOs in the state of Michigan."

The outcome of Detroit's LTGO battle is unlikely to set precedents in other states, they added.

Chicago faces its own set of challenges, chief among them one of the lowest-funded pension ratios among major cities. That makes its bonds another pocket of risk in the muni market, Schwab said. But the city's large, diverse economy and other strengths are expected to keep it from going the way of Detroit, they added.

Tobacco settlement bonds, secured by payments to states from major tobacco companies based on consumption, also pose a possible hazard, Schwab said.

With the decline in smoking and the growth of alternatives like e-cigarettes, the "future for tobacco settlement bonds is in question," said Schwab, and investors should exercise additional caution when considering the sector.

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