Don't Hold Your Breath Waiting for Muni Armageddon

What happened to the muni catastrophe? Meredith Whitney ended 2010 scaring the daylights out of municipal-bond investors by predicting "hundreds of billions" in municipal-bond defaults in the coming year. No doubt her prediction on "60 Minutes" played a part in the net redemptions seen in municipal-bond funds for most of this year.

Yet here we are at the halfway point, and defaults are running at a trickle. Rather than the $200 billion or more of defaults Whitney predicted, we've had $746 million according to Income Securities Advisor. DWS estimates that, at that rate, we'll have about $1.7 billion in defaults for the year. In fact, DWS and Income Securities Advisor's Distressed Debt Securities newsletter say defaults have dropped significantly from the prior three years. The market peaked at about $8 billion in defaults in 2008, so this year could be one fourth of that or less.

For those scoring at home, that means we've only reached 1% of Whitney's predicted default level.

You've no doubt read about the problems in Illinois, Florida, and California, where deficits have grown and governments have been forced to make cuts. But there are good reasons why the system is strained but not breaking. Governments can raise taxes and cut spending to get themselves out of their messes, and that's what they are doing. Moreover, they need to come back to municipal markets to continue to borrow so they have strong incentives to treat bondholders well.

In addition, an improving economy has meant rising tax revenues. Municipalities' tax revenues started rising in late 2010 and have continued to do so. Income tax and sales-tax revenues naturally rise as the economy improves.

This means that, if you own a well-run muni-bond fund, you're in pretty good shape. These funds usually have bonds from a hundred or more issuers, so one default won't have much impact. And, of course, they do thorough credit research to steer clear of most, though not all, defaults. With some munis paying better tax-free yields than many high-quality taxable bonds, this isn't a bad time to get in. In fact, some taxable-bond managers are even buying munis because they look attractive even without the tax break factored in. That said, fewer new munis have been issued so far in 2011, so additional waves of new debt could drive prices lower in the short term.

Investors may have noticed the divergence between dire predictions and reality as muni-fund flows turned positive in June after fairly steady redemptions. The $980 million flowing into munis isn't a huge amount but it does indicate that the fear level is dropping. I don't expect this to turn into really big inflows soon, but it may mean a market headwind is going away.

While the focus has been on credit risk, it's worth remembering that muni funds do have interest-rate risk. A surge in interest rates could lead to small losses in muni funds--even among those with shorter durations (a measure of interest-rate sensitivity).

I favor strong intermediate muni funds such as Fidelity Muni Intermediate Income FLTMX, which has a 5.4-year duration, and Vanguard Intermediate-Term Tax-Exempt VWITX, which has a 5.6-year duration.

In its past 10 calendar years, the Fidelity fund's worst one-year performance was a 1% gain and the Vanguard fund's worst was a 0.1% loss. It's certainly possible that they could do worse than that in a tough year, but I'm not going to lose any sleep over it.