If You’d Bought Muni Bonds Shortly After Meredith Whitney’s Prediction of Massive Defaults . . .

We’re coming up on the second anniversary of The Call: Analyst Meredith Whitney’s 60 Minutes declaration that we “could see fifty to a hundred sizable defaults” that would result in billions of dollars’ in losses for municipal bond holders.

That triggered a steep sell-off. Muni bond fund investors yanked $30 billion from December 2010 through February 2011, causing massive liquidity migraines.

Here’s how the iShares S&P National AMT-Free EFT (MUB) fared in the month after the call-the worst of the sell-off- compared to the Vanguard Total Bond Market ETF (BND) which does not hold tax-exempts.

MUB Chart

MUB data by YCharts

Granted, fortunes haven’t been lost on 3.7% price declines, but keep in mind that was more than the annual yield high quality munis were paying out back then. One year’s yield wiped out (and then some) by one month’s price decline.

Now it’s not exactly news that the default debacle didn’t materialize. Or to be more precise: It has yet to materialize. And after the initial sell-off subsided, the municipal market has been doing just fine.

MUB Chart

MUB data by YCharts

Adding in yields, the total return for the iShares Muni ETF is more than 25% over that stretch, compared to 12% for the Vanguard Total Bond market ETF.

While we have indeed seen a few biggish municipalities declare bankruptcy this year -- Stockton, CA and San Bernardino -- there’s a big difference between bankruptcy and defaulting on bonds you’ve issued. In 2008 Vallejo, CA declared bankruptcy. While public services have been drastically cut, bond payments have continued to be made on schedule.

Besides, unless you’ve got a big chunk of change -- think well into six figures -- to build a diversified muni portfolio without getting killed on the bid-ask spread, this is one area where a diversified ETF or fund portfolio makes a ton of sense. And the big national funds own a couple of thousand individual bonds. That’s how you sleep well at night even if there are some outright defaults in the coming years.

And to point out the obvious, with tax rates heading higher next year (the only question is whether we all get smacked, or just married households making more than $250,000 a year), municipals are surely going to be feeling some love.

Right now the average yield for AA-rated municipal bonds is 2.2%. That’s before we factor in the value of the tax break. Meanwhile, your repressed 10-year Treasury rate is 1.6% and AA-rated corporate bonds have an average yield of around 2%. So even before doing the taxable-equivalent yield math, high-grade munis are paying out incrementally more yield. If you happen to be in the 35% marginal tax bracket, that 2.2% of tax-free income is the equivalent of 3.4% taxable.

In case you're wondering, taxable dividend yield of 3.4% is currently available on the following giant-cap stocks: Chevron (CVX), Johnson & Johnson (JNJ), McDonald's (MCD) and Pfizer (PFE).

Rather than the specter of massive defaults, the one thing muni investors need to keep watch over is whether Washington actually does get serious about fundamental tax reform in 2013 and the tax-exempt status of muni bond income becomes a bargaining chip.

Carla Fried, a contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine.



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