Actions trigger a domino-effect that's driving down prices and causing discounts for individual bonds
A total of $20.4 billion has flowed out of municipal bond funds in the first quarter of 2011, according to Lipper US Fund Flows, as investors continue to flee in fear of widespread defaults by state and local governments.
The flight from municipal debt has forced muni bond fund managers to sell holdings at a loss with the effect of driving down prices for individual bonds and creating the opportunity to buy muni bonds at discounted prices.
Issuance of new bonds has also slowed. In the first quarter of 2011, according to SEC data, $44 billion in muni bonds were issued, the lowest amount since the first quarter of 2000. Today investors hold $2.8 trillion of municipal debt.
This panic selling of muni bonds illustrates the “headline risk” investors assume when they buy municipal debt obligations. The selloff began late last year when celebrity analyst Meredith Whitney predicted widespread default by cash-strapped cities and counties. Whitney maintains her grim outlook for the sector, though her predictions have yet to come true. In the first quarter of this year, there has been $12 million in municipal bond defaults, according to Rafael Costas, co-director of the Franklin Municipal Bond Department, a far cry from the $100 billion predicted.
It’s important that investors understand the difference between “headline risk” and “credit risk,” Costas said. “If an investor buys a municipal bond for its income, which in our opinion is the best reason to buy it, then headline risk is more ‘noise’ that anything else. In fact, when muni bond prices decline in response to negative headlines, opportunities are created for long-term investors to enhance the income they generate as yields increase.”