Municipal bonds buck bad news with solid returns

The super committee's failure and other economic uncertainty hasn't much hurt the muni bond market.

The financial markets have had to absorb a lot of bad news recently, including the deepening of the euro-zone crisis and the failure of the supercommittee, triggering $1.2 trillion in automatic spending cuts (including defense and domestic spending) in 2013 -- the same time that the Bush tax cuts expire.

Markets hate uncertainty, and the supercommittee's failure to reach a compromise means that with a major election next November and a dysfunctional congress, we may not get any resolution to a host of fiscal issues until well after next year.

However, the news isn't all bad for investors everywhere. One place where the news continues to be generally favorable is the municipal-bond market. For example, through Nov. 21 the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) returned 7.4 percent for the year-to-date. For comparison, stocks, as measured by the S&P 500, lost about 5 percent over the same period.

More on bonds: Don't worry over largest ever muni default

There are two reasons for munis' strong performance. First, the market ignored the March 2011 forecast by bond king Bill Gross that interest rates would go higher. Gross has since apologized to his shareholders for his bad call on Treasury yields.

Second is that states and municipalities have continued addressing budget shortfalls, meaning investors aren't experiencing the wave of defaults that some analysts (most notably Meredith Whitney) were expecting. Unlike the federal government, the vast majority of states are required to balance their budgets.

As a result, budget gaps are being closed by laying off public employees, greatly reducing services, renegotiating contracts with union members on wages and benefits and increasing taxes and fees. These actions have gotten results.

Consider Rhode Island. The state has passed major pension-reform legislation thatis expected to be signed by the governor. The plan shifts all employees except in public safety into a hybrid plan (or defined benefit plus defined contribution). It also suspends cost-of-living adjustments until certain funding levels are achieved and increases the minimum retirement age. These changes significantly reduce the state pension system's unfunded liabilities and cut the future cost of administering the plans.

Furthermore, East Providence has joined Central Falls as a Rhode Island municipality under state oversight. A state-appointed fiscal manager will oversee the finances of East Providence. This is the first step of three state interventions that can be taken under the state's Fiscal Stability Act of 2010. Receivership, as in the case of Central Falls, is the third and final form of state intervention.

In a sense, doomsayer Meredith Whitney may have been right. There will be many defaults.They just won't be defaults on bonds. Instead, they will be defaults on other obligations.

The outcomes of Gross' and Whitney's forecasts are reminders of why you should ignore the prognostications of gurus. The historical evidence demonstrates that predictions are nothing more than the equivalent of crystal ball gazing. And all crystal balls are cloudy.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.