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Municipal Bonds: Why We Likely Won't See Armageddon

As we discussed yesterday, Meredith Whitney's prediction that we would see the municipal bond market experience widespread significant defaults has (so far) fallen well short. We've only seen nine small bond defaults this year, while she was forecasting between 50 and 100 significant defaults.

While I'm not in the business of making predictions, there are several reasons why I believe investors in the highest grade bonds (the only kind I recommend: AAA/AA general obligation or essential service bonds, or single A if the maturity is three years or less) shouldn't be concerned about a tidal wave of defaults.

  • Unlike in the case of, say, Greece, debt service is a relatively small portion of most municipal budgets.
  • The average maturity of municipal debt is much longer than it is for some countries, giving them time to address their problems.
  • Issuers understand that they must maintain access to public markets.
  • General obligation debt service typically has a high priority relative to other expenditures.
  • Legal protections are strong for general obligation bondholders relative to other stakeholders.
The key takeaway is that severe fiscal stress doesn't guarantee widespread bond defaults. And it certainly doesn't guarantee large losses.

There's one other important sign that the municipal bond market won't experience the turmoil Whitney forecasted. To issue debt, some municipalities rely on credit support from banks that issue letters of credit. Given the fears of losses, one would think that many municipalities would have trouble renewing expiring agreements. However, the Wall Street Journal noted that only two issuers couldn't find alternatives to bank guarantees, and 85 percent were either renewed or replaced by another bank. In addition, the costs of many of the letters of credit actually dropped. This certainly wouldn't be the case if the credit situation were deteriorating.

Despite all the noise and record setting outflows, yields on AAA-rated municipal bonds have been virtually unchanged since the end of 2010. And the Vanguard Intermediate Term Tax-Exempt Fund (VWITX) has returned 2.8 percent through May 6. Investors who panicked and sold haven't been well served.

While it's still early in the year, and readers of my blog know I don't attach much if any value in forecasts, I'm willing to go out on a limb here and make this forecast: Meredith Whitney's forecast will be remembered alongside of BusinessWeek's "Death of Equities" forecast as among the worst of all time. Check back at year-end to see which of us was right.

More on MoneyWatch:
Municipal Bonds: Was Meredith Whitney Right? Why Buying Money-Losing Investments Can Be a Good Strategy Gold and Silver, What Goes Up... What the End of the American Age Means for Your Portfolio How to Create and Live a Fulfilling Retirement
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