Why You Shouldn’t Believe The Municipal Bond Hype

Meredith Whitney

[credit provider=”60 Minutes”]

Many investors think the municipal bond market is about to implode. Respected analyst Meredith Whitney predicted on 60 Minutes that massive defaults by the states “are the largest threat to the U.S. economy”. So, is it time to dump your municipal bond holdings ahead of the impending crash?[See 10 Ways to Boost Your Social Security Checks.]

Not according to Byran Harris, senior editor at Dimensional Fund Advisors. Harris decries the simplistic analysis that treats the municipal bond market as a single structure. It isn’t. It consists of $3 trillion in debt, with over 50,000 state and local issuers, making broad generalizations about defaults unreliable and misleading.

While the past does not predict the future, it is noteworthy that the default rate of highly rated municipal bonds is exceedingly low. From 1970 to 2008, no municipal bond rated Aaa by Moody’s defaulted. The default rate of bonds rated investment grade by Moody’s was only 0.07 per cent.

The bad publicity about municipal bonds is centered on the fiscal woes of Arizona, California, Illinois, New York, and Texas. Making broad extrapolations about defaults based on the problems of these relatively few states is unwarranted.

It’s telling that the market does not perceive increased risk in municipal bond investments. Whitney’s prediction was widely disseminated. If there was a consensus among bond traders that defaults were imminent, you would expect bond yields to rise. The opposite has occurred. Since November 2007, average yields for bonds rated AAA-, AA-, and BBB have fallen. Betting against the wisdom of the market is generally a bad idea.

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No one can predict the direction of the municipal bond markets. While the data does not support predictions of widespread defaults, that possibility cannot be entirely discounted. The issue for investors is how to manage that portion of their portfolio that consists of fixed income bonds.

Many investors need to revisit how their portfolio is allocated between stocks and bonds. Bonds should be considered the ballast in your portfolio, tempering the short term volatility of your stock portfolio. If you are concerned about risk, start by lessening your exposure to stocks and increasing your exposure to bonds.

The bond portion of your portfolio should consist of short-term, low risk bonds with an average maturity of five years or less. The best way to include bonds in your portfolio is through a bond index fund. Consider the Vanguard Short Term Bond Index Fund (VBISX). It invests about 30 per cent of its assets in corporate bonds and 70 per cent in U.S. government bonds, with maturities from one to five years. The expense ratio of this fund is only 0.22 per cent.

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If you believe municipal bonds are appropriate for your portfolio, stick to short-term bonds, stay broadly diversified, and limit your investments to those rated most highly by Moody’s and Standard & Poors. Following these basic guidelines is far more preferable than reacting to predictions of stock market analysts. They may be right or wrong, but when they are right it is more often based on luck than skill.

This post originally appeared at U.S. News & World Report.