5 Reasons to Favor Municipal Bonds â€" and 4 Reasons Not To

Last Updated Mar 23, 2011 3:11 PM EDT

The municipal bond market has taken a severe hit in recent months. Yields on 10-year munis have soared by roughly a full percentage point, a huge move, especially considering that they were yielding in the low two-percent range before yields started climbing.

The rise in yields sent prices down far enough in less than six months to wipe out about three years' worth of interest payments. Tim Pynchon, manager of the Pioneer High Income Municipal Fund (PIMAX), thinks that the selling is overdone and makes the case for buying munis in a report called "Five Reasons to Favor Municipal Bonds in 2011." Here are the five:

"Municipals are cheap and yields are up." The report notes that yields are broadly equivalent to Treasury yields, even though muni interest is nontaxable, and higher than corporate bonds of similar quality. "Historically, ratios and yields like these have represented significant buying opportunities. In our opinion, the opportunity for crossover buyers to enter the market has never been better."

"Concerns about new issues flooding the market in 2011 may be overblown." Instead it appears that issuance in the fourth quarter was so great, Pynchon says, that new supply may actually may fall in 2011.

"The fundamentals of most revenue bonds are healthy, as are the fundamentals of many general-obligation bonds." To the uninitiated, the first kind are issued to fund specific projects, like dams or bridges, and the bonds and their holders live and die by the success of each project. General-obligation bonds are the sort for which the issuing state or municipality is on the hook, regardless of how the money is spent, and are generally considered safer.

"Don't believe the hype about defaults." Pynchon points to scary forecasts from uber-analyst Meredith Whitney of 50 to 100 "major defaults" and "hundreds of billions in defaults" in 2011. He counters that the eventual default rate "should not approach the scale that Ms. Whitney predicts."
"States cannot go bankrupt." The report notes that states and some cities and counties "are not legally allowed to file for bankruptcy and would therefore be highly resistant to default for fear of severe repercussions in the investor community." Pynchon also believes that the federal government would intervene to prevent such an unfortunate development "to avoid the fallout that such an event would create."

So, ready to rush out and buy? First, consider these reasons to hold off:

Treasury yields are likely to rise. Muni yields are figured as a spread above or below the yield on Treasury bonds of the same maturity. Treasury yields have been artificially depressed lately by hundreds of billions of dollars of bond purchases in the Federal Reserve quantitative easing program, or QE2. When the Treasury stops buying and starts selling to unwind its positions, which it will be under pressure to do eventually, yields are bound to go up, taking muni yields up with them.

States will continue to be seriously strapped for cash. Don't underestimate how desperate they are and how little political will there is nevertheless to cut spending. Officials in Wisconsin, Ohio and Indiana made brave attempts to cut spending and got rhetorical civil wars - like Libya without bombs or a no-fly zone - for their trouble. It remains to be seen how much belts can be tightened in places like California, New York and Illinois.

Raising taxes is not an option in a lot of places. California is going to give it a whirl, but with unemployment still stubbornly high, it's a 50-50 proposition at best in many states. Meanwhile, with significantly higher taxes not a real threat at the state or federal level, the attractiveness of muni bonds diminishes.

States cannot go bankrupt. Pynchon sees this as a positive, but it's not. If states had that option, it would concentrate the minds of public-employee unions and persuade them to make concessions on pension and health benefits, perhaps the most serious drain on state budgets. If states are ever granted the right to file for bankruptcy, there probably would be a large, immediate run-up in rates that would provide a spectacular buying opportunity.