Municipal bonds traditionally have been a refuge for the risk-averse, as many are backed by the full faith and credit of state and local governments, but those same investors lately have been bailing out at a record rate.
A few factors can be blamed for this sudden retreat, but the one making all the headlines is the fear that cash-strapped states and municipalities issuing the bonds will renege on promises to investors.
Those simmering concerns were stoked last month when respected banking analyst Meredith Whitney warned on "60 Minutes" that 50 to 100 or so cities and counties will default on "hundreds of billions of dollars" of municipal bonds.
Many bond experts scoff at Whitney's prediction, saying it's wildly off the mark. The worst year for municipal bonds in the past three decades was 2008, when 162 issuers defaulted on bonds totaling $8.1 billion — not hundreds of billions — according to the Distressed Debt Securities Newsletter, which tracks defaults.
Still, bond experts acknowledge that states and municipalities face severe financial strains. These experts don't suggest avoiding municipal bonds, but they say investors can no longer buy any old bond and assume their investment is safe.
"They have to be extremely picky," says Marilyn Cohen, author of "Surviving the Bond Bear Market," which is scheduled for release in March.
State and local governments issue municipal bonds to build schools, hospitals, roads and other projects. The bonds appeal to investors in higher tax brackets because the interest is generally exempt from federal taxes and — if the bond is issued within their home state — from state and local taxes, too.
Municipal bonds traditionally have low default rates, so investors rushed into them for safety and higher yields after the stock market crash in late 2008. But this past November they started pulling out in big numbers.
Net outflows from municipal bond funds reached $7.9 billion in November, according to the Investment Company Institute. Estimated outflows last month hit $13.35 billion, a record in the 27 years that ICI has reported the figures.
Bond experts blame the exodus in part on rising rates on Treasuries, which caused investors to worry that the value of their muni bonds would fall and prompted some to seek higher returns elsewhere.
On top of that, it became clear near the end of the year that the federal Build America Bonds program wasn't going to be extended beyond 2010, says Hugh McGuirk, head of T. Rowe Price's municipal bond group. Subsidies from this stimulus program made it cheaper for states and local governments to borrow by issuing taxable bonds. With the demise of the program, more tax-exempt municipal bonds are expected to come onto the market and push prices down, McGuirk says.
Headlines about the financial problems of states and municipalities also likely added to investor anxiety. Pennsylvania's capital, Harrisburg, nearly defaulted on a bond payment last fall before the state came to the rescue.
Then last month Whitney made her dire prediction for the coming year on national TV. Ever since Whitney correctly forecast problems in the banking sector a few years ago, her observations have carried a lot of weight. She told "60 Minutes" that she doesn't expect any states to default, but that cities and counties would have sizable defaults. She reaffirmed her outlook last week on CNBC.
Mitch Schlesinger, chief investment officer at FBB Capital in Bethesda, says clients are concerned.
"And rightly so, given all the news that's going on in municipal finances" across the country, he says. He's not avoiding muni bonds but warns that "you have to be much more careful than in any time in the past."
Richard Lehmann, who publishes the Distressed Debt Securities Newsletter, agrees that defaults will go up this year. About 100 to 200 bond issues default each year, and "that is likely to accelerate now that municipalities have hit the wall," Lehmann says.
But he expects $3 billion to $5 billion in bond defaults, not hundreds of billions. "Anything above $2 billion is a high default rate," Lehmann says.
Many bond experts take issue with Whitney's forecast.
"Meredith Whitney should stick to evaluating bank stocks," says Dick O'Brien, an executive vice president with Folger Nolan Fleming Douglas Inc., a brokerage in Hunt Valley. Governments will do whatever it takes to avoid defaults so they can continue borrowing through the muni bond marketplace, he says.
"Governments are tightening their belts. They are raising taxes. There are all sorts of things that issuers can do prior to defaulting on their debt," O'Brien says. ("60 Minutes" also featured a clip of Maryland Gov. Martin O'Malley saying, "Cuts, cuts, cuts and more cuts.")
T. Rowe Price's McGuirk adds that even if defaults tick up, there are still plenty of choices for investors in the $2.8 trillion municipal bond market, which has at least 40,000 issuers. "It's a broad and diverse market," he says.