Municipal bonds continue to rally

The municipal bond market continues to defy the experts, with minimal defaults and a strong rally. According to research firm Municipal Market Data, there were only $6.1 billion in defaults last year (0.1 percent of the muni market), of which $3.5 billion (almost 60 percent) represents American Airlines special facility bonds. (The company filed for Chapter 11 bankruptcy in December.)

The municipal credit outlook continues to improve as tax revenues for state and local governments recover. The third quarter saw year-over-year tax revenues rise 4.1 percent, the eighth consecutive quarterly increase on a year-over-year basis. Property, sales, and personal income tax receipts also continue to improve. Total tax receipts are now above pre-recession levels, though individual income tax receipts haven't fully recovered. Such improvement, coupled with expense reductions and renegotiated labor contracts, has allowed states to rebuild their reserves. However, at less than 4 percent, they remain well below the 10 percent level of 2006.

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Because of this rebound, new issuance of municipal bonds remains slow. The reduced supply helped fuel the municipal bond rally we saw in 2011, and the rally continued into January. The spread between 10-year Treasuries and 10-year AAA municipal bonds, which started the fourth quarter at more than 115 percent, is now below 90 percent.

This healthier environment calls to mind the forecast Meredith Whitney made at the end of 2010, when she predicted municipal bond defaults totaling hundreds of billions in 2011. This serves as a reminder of why it's often wise to tune out the dire predictions of investment gurus.