By Ben Baden

Before turning positive in June, muni bonds funds experienced seven consecutive months of outflows

Turn the clock back to late 2010, and all the talk in the investment community was about potential Armageddon in the municipal bond market. In December, analyst Meredith Whitney famously predicted a "sizable" number of defaults in the municipal bond sector, in the range of 50 to 100 that would result in losses of hundreds of billions of dollars for investors. Midway through 2011, not a single rated municipality has defaulted on its debt this year.

Municipal bonds, which are generally regarded as some of the safest investments available, are issued by states, municipalities, or counties, and are usually exempt from federal, state, and local taxes. Since 1970, there have only been 57 rated defaults, including three in 2010, according to Moody's Investors Service. The majority of those have come from outside the general obligation sector. (General obligation bonds are backed by the full faith and credit and unlimited taxing power of a particular municipality.) Most of the defaults were in non-essential sectors like healthcare and housing.

"We've seen a number of what we refer to as 'near misses,'" says Robert Kurtter, managing director in public finance at Moody's. "They will probably get a lot of press attention, but often they get resolved because of higher levels of government, typically the states."

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Kurtter isn't ruling out defaults in 2011, but what he's predicting isn't anything close to "sizable." "We do think that there could be more defaults in the general government sector in 2011 and 2012 -- perhaps more than the very low number that there have been, but not widespread at all," he says.

That's because state and local governments are strapped. As the nearly $1 trillion federal stimulus program winds down, most states, unlike the federal government, must balance their budgets through spending cuts, tax hikes, or a combination of the two. "In our view, state and local governments continue to experience unprecedented fiscal stress," Kurtter says. "We've had negative outlooks on the state government sector and the local government sector for three years now."

For 10 consecutive quarters, ratings downgrades of U.S. public finance credits by Moody's have outnumbered upgrades, as of the second quarter of 2011. Of the 170 ratings changes in the second quarter, 127 were downgrades and 43 were upgrades. That's a downgrade-to-upgrade ratio of about 3 to 1. (The ratio peaked at almost 5 to 1 in the fourth quarter of 2010.) "It's the longest period of that trend that we have since we've been keeping such records," Kurtter says. "And we expect the pressure to continue."

Nervous retail investors have responded accordingly. Since November 2010 when the net outflows first began, investors pulled more than $42 billion from muni bond funds, according to Morningstar. (For comparison's sake, they invested nearly $95 billion in taxable bond funds over the same time period.) But after seven consecutive months of outflows, the trend may be reversing. Munis funds saw inflows of almost $1 billion in June. "The very dire default projections just haven't materialized," says Miriam Sjoblom, associate director of fund analysis at Morningstar. "The pressure of investors leaving the market has abated."

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But plenty of risk still remains in the normally tranquil muni bond market. Last week, Moody's issued a warning about the effects of a default by the federal government on its debt, and the impact that could have on municipalities. Moody's said it was placing the U.S. government's debt rating on review for possible downgrade, adding: "This action has consequences for the ratings of municipal credits that are directly linked to the U.S. government or are otherwise vulnerable to sovereign risk." This warning affects about 7,000 different top-rated muni issues. Experts say there is still a very low probability that Congress will not pass the debt ceiling, but if the government actually defaulted on its debt, it's not clear what the impact would be for state and local governments.

Rob Williams, director of fixed-income research at Charles Schwab, says a ratings downgrade of the federal government wouldn't necessarily translate into massive muni defaults. "Most state and local governments' credit quality will stand on their own," Williams says. "I don't think there is a clear connection between the credit quality of state and local governments ... and what could happen if there is a change in the U.S. treasury rating." A downgrade would obviously send massive ripples throughout the bond market, but Williams says it could actually boost demand for munis as investors sell treasuries and look for other safe-haven assets.

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Going forward, Sjoblom says, the worst may be over, but investors should still be prepared for more volatility than they've seen in the past. "This is the new environment that we're in after the financial crisis," Sjoblom says. "No one is under any illusions that there isn't credit risk in the muni market. There is credit risk in the muni market."


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