I once heard a comedian tell an audience, “Never forget that you are a completely unique individual … just like everyone else.”

It’s a good line – one that reminds me how often investment analysts and various gurus who claim to offer “fiercely independent” advice generally end up saying much the same thing.

Take municipal bonds, for example – those supposedly safe securities issued by states, counties and cities to finance public works and which pay interest exempt from federal income taxes (and some state ones).

[ad#Google Adsense]If you’ve been paying any attention at all, you’ve heard that the next shoe to drop – the next big financial crisis – will be major defaults by California, Illinois and other states with huge fiscal imbalances.

It won’t happen. Here’s why…

No Fluff… Just the Facts Let me begin by saying that any pending crisis on everyone’s radar screen is usually no crisis at all. (Remember Y2K?) A genuine crisis, almost by definition, is unpredictable.

How can all these “independent” analysts and Wall Street Cassandras be wrong? Mostly because they all have a tendency to listen to each other and adopt the viewpoint du jour, rather than looking at the plain facts.

So let’s do just that.

  • Fact #1: Municipal bonds have plunged over the last several weeks, as the consensus has grown that we’ll see widespread defaults this year.
  • Fact #2: Financial analyst Meredith Whitney, in particular, expects that we’ll see 50 to 100 American cities go bust this year and the defaults will amount to hundreds of billions of dollars.

A lot of investors are listening, apparently. The Wall Street Journal reports that municipal bond funds have seen $22.7 billion of withdrawals since November 10 – about two-thirds of the $34.5 billion that had been invested since January 1, 2010.

Vanguard even withdrew the offering of several muni bond ETFs, citing chaotic and uncertain market conditions.

Digging Out of the Deficit Abyss I’m not Dr. Pangloss. I realize that state budget deficits will increase from $120 billion this year to almost $150 billion next year, thanks largely to underfunded pensions and growing healthcare costs.

Yet many analysts assume these deficits will just keep growing in perpetuity. They won’t.

Look at New Jersey Governor Chris Christie, for example. He’s stood firm against unhappy public employee unions – a group that traditionally tells political leaders what they “must have,” not what they “want” – and his poll numbers have surged.

In California, Governor Jerry Brown announced $12.5 billion in spending cuts on January 12. That same day, Illinois raised its state income tax to 5% from 3% to help plug an estimated $13 billion shortfall. (I’m not applauding this, just pointing it out.)

Moreover, revenue for U.S. municipalities as a group rose during the first three quarters of last year – and the trend will almost certainly continue as the recovery takes hold.

What Caused the Muni Bond Selloff… And What Will Arrest the Slide Yes, there will be muni bond defaults this year. Lots of them. But they’ll be mostly small, weak municipalities. Not even muni bond super-bear Meredith Whitney predicts that any state will default on its debt.

Bear in mind, much of the recent selloff is due to reasons other than fear of major defaults. For instance…

  • The extension of the Bush-era tax cuts for two years took away the urgency to invest in tax-free bonds.
  • Muni bonds also sold off, in part, because of a broader slump in U.S. Treasury securities.

But there are several reasons why this rout should soon come to an end.

For starters, many muni bonds now yield more than taxable bonds. And with top marginal rates likely to rise – not fall – in the years ahead, high-net-worth investors will step in to take advantage of this unusual situation.

[ad#ChinaBlankCheck]For example, many 30-year AAA tax-free bonds now yield over 5%. If you reside in the top federal tax bracket, you’d have to earn almost 8% in a taxable bond to get that kind of after-tax yield. In this interest rate environment, that’s nothing to sniff at.

Plus, municipal bond issuance will drop to $350 billion this year from $430 billion last year. If you took Economics 101, you know that decreasing supply generally firms prices up.

Fears of the Muni Bond Demise Are Greatly Exaggerated I know most investors will scoff at the notion that a muni bond crisis isn’t dead ahead. They’ve heard the media and Chicken Little analysts repeat their dire warnings so many times, they believe a muni bond debacle is a virtual certainty.

But a few independent thinkers agree with me. One of them is Bill Gross, the man who manages more fixed-income assets than anyone else on the planet. The Pimco chief recently declared, “I don’t subscribe to the theory that there will be lots of municipal bankruptcies.” You shouldn’t either – and in my next column, I’ll point out a few great bargains in the sector.

Good investing,

Alexander Green

[ad#jack p.s.]

Source: Investment U