Despite dire warnings of imminent government collapse, since the middle of 2009, only three municipal issues in the “safe” sectors--general obligation, tax backed and essential services—have defaulted, according to Municipal Market Advisor’s data.

But with money fleeing municipal funds--investors yanked $2.9 billion last week, according to Lipper,  and $15.2 billion over the past six weeks — the biggest outflow over any six-week period ever, your clients may be asking you if they should hold tight. Or see the flight as an opportunity and buy.

Corporate bonds have been most popular, with 2.5 percent inflows over the past three months.

Meanwhile, Pimco's Bill Gross says 6.65% for New York City Build America Bonds and 7% percent plus in Califonia are good bets for investors who want higher yields than Treasuries. Gross, who helps run the world's largest bond fund, recently put up $5 million to buy shares of five municipal funds.

Star banking analyst Meredith Whitney, who forecast disaster for America's big banks before the credit crisis struck, has been saying for months that local-government defaults would be the next phase of the housing meltdown. The most recent scare came on CBS’ “60 Minutes,” when she said we could see 50 to 100 sizable defaults of local governments next year.

In June, Warren Buffett spooked muni investors when he told a federal commission that the ratings on municipals were essentially a bet on whether the federal government would back them up in a crisis. “ I don't think Moody's or Standard & Poor's or I can come up with anything terribly insightful about the question of the state and municipal finance five or 10 years from now,” he said,“except for the fact there will be a terrible problem and then the question becomes will the federal government” intervene.”

Although Moody’s placed all local governments on “negative watch” in the summer of 2009, municipal market defaults and bankruptcies remained low 2010.  As Tom Kozlik, a muni analyst at  Janey Montgomery Scott, points out, states are in no danger of missing payments and defaults among local governments are still rare. “I do not see any facts leading us to think default experience will be excessively higher in 2011, “ he says.

Bondholders in the $2.8 trillion municipal market have largely escaped big losses in Chapter 9 cases because much of muni debt is secured by special liens and tax pledges.  Also, states have tight control over whether local governments can default. Twenty one states don't allow municipalities to go bankrupt, so you might check whether that is the case for your clients’ holdings.

Unlike corporations, municipalities cannot be liquidated, even in times of severe financial distress. A local government entity will continue to exist.  Local governments can raise revenue and lease or sell off assets. Miami's city council, for example, used emergency powers to slash city salaries and pensions and put in hefty traffic fines and garbage fees. Harrisburg, Pennsylvania, was scheduled to default on a $3.3 million bond payment when Pennsylvania's governor, Ed Rendell, stepped in with $4.4 million from the state's own strapped budget

Vallejo, Calif., which sought bankruptcy protection in 2008, is still negotiating with holders of $52 million in debt. A state-appointed receiver has taken charge of Central Falls, Rhode Island. In 2010, ratings agencies have cut the debt in several cities -- including Littlefield, Tex., Detroit, Mich. and Bell, Calif. -- to junk.

Looking back from 1970 to 2009, Moody’s counts 54 defaults, mostly in healthcare and housing projects.  The average 5-year historical cumulative default rate for investment-grade municipal debt is 0.03%, compared to 0.97% for corporate issuers, while for speculative-grade debt the rates are 3.4% and 21.4% for municipals and corporate issuers respectively.

Historical recovery rates for defaulted US municipal bonds are also high. The average historical 30-day post-default trading price for municipal bonds is $59.91 relative to a par of $100 for the period 1970-2009, much higher than the $37.50 average recovery for corporate senior unsecured bonds over the same period.

Most market watchers expected a rally in munis to begin in 2011. One issue is a very heavy supply of new bonds in the fourth quarter, which slowed down in December  and most forecasters see fewer new bonds in 2011 than in 2010.






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