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Meredith Whitney versus Bill Gross. They have competing and opposite views of the municipal bond market. Whitney forecasts a reprise of the ’08 banking crisis with widespread municipal defaults; Gross and many others believe such fears are overblown, pointing to low historic default rates as evidence.

Here’s the problem as I see it. Gross is probably right – the most likely outcome is that several dozen or so municipalities fail, and perhaps many (if not all) are bailed out by their respective states. Things will probably work out. However, that assessment doesn’t mean munis are a great investment. Bond investors implicitly sell put options on the companies whose bonds they buy. That is to say, if the issuer continues to prosper, they receive their option premium in the form of a yield above treasuries; if the issuer fails, they lose many multiples of their option premium. The probability of default needs to be generally a low single-digit percentage for this to make economic sense.

Now the toothpaste is out of the tube, so to speak, as muni defaults are being openly debated. Every day pundits on CNBC and elsewhere offer their views. Meanwhile, the muni market continues to experience selling – to pick just one example, the Nuveen Municipal Value Fund (NYSE:NUV) has lost 10% in value since its September high (even including distributions).

To a considerable degree, everything will be fine if everyone believes it will be fine. It’s analogous to the slowly unfolding sovereign debt crisis in Europe, where investor avoidance of the peripheral countries drives up their financing costs and makes them weaker credits as a result. As investors assess the value of the put options they are implicitly selling to be higher, it can create funding pressures that are self-fulfilling.

So today an investor in municipal bonds is betting not so much on default risk as on the behavior of his fellow investors. That’s a very different risk than is traditionally faced by income investors in a normally staid and opaque corner of the bond market. In exchange for a put option premium of a few percent, investors are taking the small but not insignificant risk of their capital being tied up (if, for example, an issuer was unable to roll over existing debt) or even a capital loss if an issuer does default and is not bailed out by its state government.

The economy’s recovering. Treasury yields will probably drift higher. In a year’s time the issue will probably have resolved itself, either through a drop in Whitney’s reputation or something far more catastrophic. Stepping away from the muni market for a year, and giving up that annual put option premium, seems a wholly sensible move for the individual investor.

Come back next year. By then, the muni market will probably be devoid of nervous investors. The outlook will be clearer, the holders of bonds more confident, and the risk profile substantially different.

Source: Why Municipal Bonds Aren't Worth the Risk