The municipal bond market has confronted turmoil in recent months. The turmoil, however, is primarily the result of fear, which means it may not be necessary to avoid municipal bonds altogether.
Many states are dealing with severe budget shortfalls, raising concerns that they may not be able to meet their obligations to bondholders. One investment strategist even predicted we could see 50 to 100 municipal bond defaults this year.
Such fears have driven up yields on municipal bonds, which has driven down prices. In turn, investors took a net $20.9 billion out of municipal funds in November and December 2010, according to Morningstar, further driving down prices.
To put the current situation in perspective, defaults are uncommon.
There were just 54 between 1970 and 2009 out of 18,000 municipal issues, according to Moody’s Investors Service.
And even when defaults occur, investors usually recover most of their money.
Moreover, after past sell-offs – like in 2004 and 2008, when municipal bonds lost 6% and 10%, respectively, according to the Wall Street Journal – the municipal bond market recovered relatively quickly.
Investors who appreciate the potential benefits of municipal bonds may not want to abandon the asset class altogether. Instead, they should take precautions.
You may want to start by assessing how much of your portfolio you want to have in municipal bonds and re-allocating assets as necessary. You may also want to ensure that that majority of your assets are in municipal bond funds that keep most of their portfolios in high-quality issues (perhaps AA or higher). Finally, you may want to stick to national municipal bond funds.