Why Muni Bond Fears Are Overblown

There's no shortage of chatter about the challenges facing the municipal bond market. Headlines about deeply indebted states and cities – combined with the Federal Government's own soaring debt – have provided ample ammunition to muni bond bears.

Meredith Whitney, an analyst who made her name forecasting trouble for banks ahead of the financial crisis, began arguing last September that big defaults are ahead in the $3 trillion muni bond market. Her comments rocked the market, led to outflows from muni bond funds and sent various muni bond ETFs reeling.

Video: Are Muni-Bond Fears Overblown?

With many cities and states facing dire financial situations, WSJ's Dave Kansas talks with SmartMoney's Janet Paskin about the risk of investing in muni-bonds and the likelihood that some municipalities could default on those bonds.

Should investors be concerned about all the heavy breathing? Mostly, the answer is no. Muni bonds remain a relatively safe way to invest and earn money in a tax protected fashion. It's not sexy, but sometimes slow-and-steady wins the race.

There are, of course, caveats and investors should always pay attention -- the financial crisis has taught us that the seemingly sacrosanct can surprise. Even seemingly super safe money funds got caught in that inferno.

Much of the muni bonds "safety" reputation stems from investment-grade ratings. If a big state, say California or Illinois, gets downgraded below investment-grade, that will certainly be a red flag for that locality. But shrewd muni bond investors always remember that, like real estate, munis are a highly localized market and a broad downdraft in the wake of such a move (which remains speculative) would present opportunities elsewhere.

Here are three additional things to bear in mind when thinking about all things muni.

• History . The stories of past defaults aren't always explained. The term default has many meanings.

• Variety . There are many flavors of muni bonds, and some are safer than others.

• Interest rates . The rate environment is shifting, which may overtake all the talk about defaults.

First, history. As you've no doubt read elsewhere, the history of muni bond defaults is incredibly small. According to Moody's Investors Service the average default rate for investment-grade muni bonds is 0.03% -- sharply lower than for similarly rated corporate bonds. In the four decades before 2010, Moody's said 54 rated bonds defaulted.

Default, of course, means many things. At first glance, one would think a default would mean the investor got hosed. But usually, that's not the case.

In one of the highest profile defaults, the Orange County, Calif., 1994 bankruptcy, muni bondholders were ultimately made whole. More recently, Harrisburg, Penn., "defaulted" in Sept. 2010 when it missed a bond payment. Days later, the state stepped in and the bond holders were made whole.

One of the more famous bond defaults is the Arkansas default in 1933 during the Great Depression. After much haggling between bondholders and the state, eventually the bondholders were paid off after Arkansas raised taxes to fund the bonds. (Joe Mysak, the maestro of all things muni, chronicled this moment in history .)

Now, of course, the default rate isn't zero. In the 1970s, the Washington Public Power Supply System defaulted on $2.25 billion in bonds when its plan to build five nuclear power plants went a cropper. Investors recovered between a dime and 40 cents on the dollar.

But the WPPSS bonds were tied to a specific plan – the building of power plants. And therein lies the next lesson.

There are many types of muni bonds, and those tied to a specific, prospective thing, such as building nuclear plants, tend to be among the riskiest. Here are the main types of munis:

General Obligation (or "GO") bonds . These bonds are backed by the issuing government's full faith and credit. In other words, they are promising to pay back the bonds no matter what. Governments have a lot of tools to make this happen. The biggest, of course, is raising taxes, which is what Arkansas did back in the 1930s. Given the power to raise taxes, governments are in a strong position to honor their GO bond obligations. These are considered the safest of the historically safe muni bond environment.

Assessment bonds . These are based on taxes, usually property taxes, collected to make general improvements (street lighting, road works, county parks). Given that these are based on the issuing authorities ability to raise and collect taxes, this is also considered a safer muni bond.

Revenue bonds . These bonds are based on the specific revenue streams of an entity. Here the researching of a bond becomes much more important. For instance, bonds tied to the Triborough Bridge & Tunnel Authority are generally considered a good bet because the TBTA has a long track record. Moreover, it can raise tolls on its bridges and tunnels to meet future obligations. But not every project is so clear-cut (see WPPSS above). Generally, however, revenue bonds tied to projects with a track record and the power to raise money through increased pricing are considered safe-ish bets, even if not as safe as GO bonds.

A key element to all the above bonds is the investment rating. If the bonds have investment-grade ratings, the odds of the bonds paying off for the bondholder are quite good. Below investment-grade, the betting is more unpredictable. In this environment, there's wisdom in sticking with investment-grade bonds.

Lastly, we come to the elephant in the room that too few are discussing: interest rates. As with all fixed-income assets, as interest rates rise, the price of the asset declines.

This is not an issue for muni bond investors who buy their bonds and hold them to maturity. And this covers most investors. They are buying muni bonds for the tax benefit, the preservation of capital and the predictability of the interest rate payment over time.

But for muni bond investors, a rising interest-rate environment will have a downward impact on prices.

After years of lower interest rates and current record-low short-term rates, expectations are that rates will start to rise this year. The Federal Reserve is expected to start raising short-term rates later this year or early in 2012. Most economists also expect long-term rates, or yields, to rise. The 10-year Treasury yield is at 3.35%, already well above the 2.8% yields of last fall.

So, while defaults grab all the headlines, the bigger risk ahead for muni bonds will likely come from rising interest rates.

Dave Kansas blogs at at The Wall Street Journal's Marketbeat .