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The Muni Bond Myth

Some 18 months ago, bank research analyst Meredith Whitney is predicted that the dire straits of state and local finances would trigger a collapse of the municipal bond market that would resemble the Sack of Rome. She believed that total defaults could hit 2,000 issues and reach $100 billion in value. Those sharp edged comments caused the main muni bond ETF (NYSEARCA:MUB) to plunge from $106 to $97.

So how did that forecast do? Since then, muni bonds have been one of the top performing asset classes in the financial market. (MUB) has soared from 92 to 113, a gain of 23%. As for the number of defaults? The amounted to a handful worth only a few million dollars. Try again Meredith!

I didn't buy it for a second. States are looking at debt to GDP ratios of 4% compared to nearly 100% for the federal government, which still maintains its triple "A" rating. They are miles away from the 130% of GDP that triggered defaults and emerging refinancing's by Greece, Portugal, and Ireland.

The default risk of muni paper is vastly exaggerated. I have read the prospectii of several California issues and found them at the absolute top of the seniority scale in the state's obligations. Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment is missed to bond holders.

How many municipal defaults have we actually seen in the last 20 years? The nearby City of Vallejo, where policemen earn $140,000 a year, is one of the worst run organizations on the planet. And Orange County got its knickers in a twist betting their entire treasury on a complex derivatives strategy that they clearly didn't understand sold by, guess who, Goldman Sachs. They were recently joined by the city of Stockton, California. To find municipal defaults in any real numbers you have to go back 80 years to the Great Depression.

My guess is that we will see a rise in muni bond defaults. But it will be from two to only 20, not the hundreds that Whitney is forecasting. Let me preface my call here that I don't know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruit with the "C" average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with hedge funds, major offshore institutions, and foreign governments for whom the tax advantages of owning munis have no value.

However, I do know how to use a calculator. Top quality "AAA" muni bonds now carry 3% yields. If you buy bonds from you local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield as high as 6%, depending on where you live. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.

Since the tax advantages of these arcane instruments are highly local, sometimes depending on what neighborhood you live in, I suggest talking to a financial adviser to obtain some tailor made recommendations. There is no trade for me here. I just get irritated when conflicted analysts give bad advice to my readers and laugh all the way to the bank. Thought you should know.

There is another factor that will support this market. When taxes go up, and they almost certainly will no matter who wins the presidential election, the tax free aspect of muni bonds also increases. That makes them a "buy" in my book. But only a buy and hold. They way to play it safe here is to only invest in maturities that match your cash flow needs. They way you can ignore the market gyrations and hold everything to maturity. For most investors, that means limited maturities to 10 years or less.