When it comes to the municipal bond fund market, don't expect any buy signals from Jonathan P. Kahn. He characterizes the muni fund market as a fool's paradise and believes investors in muni bond funds will only be further disillusioned.

"It's a bad, deceptive product, filled with pitfalls," claims Kahn, a private investor who lives in New York City and invests for his own accounts. He is a longtime client of Bill Hayes, a principal of Charles Carol Financial Partners based in Washington, D.C., and Boston, and a former representative in the Fidelity Investments Private Asset Group, where the client minimum is $1 million.

"It's easier to buy individual bonds and get your money back at whatever maturity you choose, so why buy a fund for diversification as opposed to doing a little homework?" Kahn maintains. "Like many say that life insurance is sold not bought, the same applies to municipal bond funds. If you're looking for gains, stay in the stock market" rather than muni bond funds.

The $2.9 trillion muni market is going through an identity crisis. Its holy sacraments of reliability and safety have come under attack. Threats of default by states and municipalities have roiled a once-placid sector whose low-risk, low-return vehicles year in, year out were almost unalterable givens.

Muni prices were especially hit in the early fourth quarter when investors faced pessimism over defaults. That attitude was characterized by bank analyst Meredith Whitney, who made a well-publicized prediction in December 2010 that there would be 50 to 100 municipal defaults totaling hundreds of billions of dollars in 2011. It caused a steep sell-off. But even before that, many muni investors had begun retreating to other harbors.

From October 2010 through late February 2011, over $37 billion flowed out of muni funds, according to the Investment Company Institute.

The main culprits are lack of adequate disclosure and wounds to the safety record of muni bonds, discontinuation of a federal bond subsidy program, combined with the steady drumbeat of headlines about state and budget shortfalls, according to experts. Also unsettling have been revelations that states face up to $1 trillion in pension and benefits shortfalls.

A consulting firm co-founded by well-known economist Nouriel Roubini added fuel to the fire in March 2011 by predicting there would be close to $100 billion in defaults over the next five years. The fact that both Whitney and Roubini had correctly predicted troubles ahead of the 2008 financial crisis lent an aura of omniscience to their pronouncements.

But aside from these problems, real and perceived, the main fear looming over the bond market these days is more visceral: the fear that the Federal Reserve may soon raise interest rates, which would lower bond prices and investor returns. Fed Chairman Ben Bernanke went to Congress earlier this year and discussed the potential for raising interest rates.

In the wake of such events, how should you counsel clients? Are munis a category to be avoided at all costs, or is that an overreaction?

Some advisors are not waiting for the dust to settle to find out. "I took all my clients out of munis four years ago-once muni yields on 'AAA' bonds overtook Treasury yields," says veteran advisor Bert Whitehead, president and founder of Cambridge Connection Inc. in Franklin, Mich. "The smart money managers were getting the message that munis were riskier than Treasurys, and that differential has been increasing every year."

Still, while not dismissing entirely the threat of future defaults, the overall preponderance of market opinion is that there's been an unwarranted rush to judgment on munis that isn't supported by the historical record.

For instance, despite their budget-balancing difficulties, states are not overburdened with debt, according to experts. Overall, only 5% of state and local government expenditures are dedicated to interest payments, according to the Center on Budget and Policy Priorities, a proportion nearly unchanged since the late 1970s.

Others say the prediction of future massive defaults is exaggerated. They point to increased tax receipts for states and municipalities in recent years and, ultimately, the taxing power both have to make up shortfalls. Defaults are sure to rise, they say, but only slightly from historical averages of less than 0.25% per year.

Lyle Fitterer belongs in this camp. The head of Wells Capital Management's Municipal Fixed Income Team, the investment arm of Wells Fargo & Co., which manages $25 billion in muni mutual funds, debunks any perception of massive future defaults, and sees a buying opportunity.

"If you look at historical defaults, they've actually been declining," Fitterer points out. "They peaked in 2008, and they've been coming down since.

"Are they going to look like they've looked over the last 40 years? No, they're going to be higher than they've been because we're been through a rough economic environment. But on the flip side, revenues for states are improving. Year over year, revenues at the state level have actually been up four consecutive quarters," he says. "Last quarter [the fourth quarter of 2010] they were up roughly 6.8%-6.9%."

What's more, property taxes, on average, a big driver of revenues for many local municipalities, have actually continued to climb in the face of declining housing prices, Fitterer noted. "There's a misconception that just because housing prices have gone down, it's just a matter of time before property taxes go down; that's just not the case."

Still another misconception, he says, is that problems within the muni market somehow equate with problems in the housing market.

"You have to look under the covers and say, if one credit is going to default does that mean the entire market is going to default, like the entire housing market did where you had a bunch of mortgages that were all rated 'AAA'? Our market doesn't work like that," Fitterer says. "There are issues that are totally separate and distinct from one another. There are some similarities, but for every one credit that could default, there are probably 200 credits that are not going to default or even think about defaulting."

Fitterer also says that in a rising interest rate environment, munis historically have provided better price protection because of the tax-exempt income they produce. A 10-year muni usually trades around 75%-80% of the yield on a 10-year Treasury. Therefore, if 10-year Treasury yields increase by 100 basis points, 10-year muni yields should only increase by about 75-80 basis points. This equates to less downward movement in municipal bond prices relative to Treasurys.

John R. Mousseau, CFA, managing director and portfolio manager of the tax-free section of Cumberland Advisors, an RIA firm headquartered in Sarasota, Fla., says long-term tax-free bonds currently offer the best buying opportunity he has seen in over a year.

In Mousseau's view, the meltdown came about because of a "perfect storm" of several events. "You had higher Treasury rates, a spike in the tax-free [bond] supply due to the Build America Bonds (BABs) program being discontinued. This supply spike contributed to a drop in prices, which in turn spurred muni fund redemptions. This was exacerbated by Meredith Whitney's predictions of defaults-which we disagree with."

Normally, the tax-free bond market is retail driven, not institutionally driven. Things have gotten turned around, says Mousseau. "Now you have institutional money in the taxable bond market buying municipal credit because of the generous spreads over Treasurys, while the retail investor in the tax-free bond market is abandoning municipal credits."

Muni fund manager Guy Benstead, who helms the $178 million Forward Long/Short Credit Analysis Fund, blames the turmoil on a combination of scare-mongering headlines and actions by states like Illinois (in raising taxes) and California (in proposing an extension of tax increases set to expire this year as a way to help balance the state budget).

Benstead maintains states have an ample supply of muni bonds available, since many have already issued muni bonds for this year, and he predicts a rush back to munis in the second half of 2011, barring a rise in redemptions, which will push prices up.
Mike Walls, who manages Ivy Municipal High Income Fund and the Advisor Municipal High Income Fund, with a total of $930 million in assets in both vehicles, basically agrees.

"The problem is that non-muni people try to portray the market as a plain vanilla market, and it's much more dynamic than that. The vast majority-about 70% of bonds in the muni market-are revenue bonds," says Walls. "These have specific earmarks, a revenue source that's meant to pay back bondholders."

The Ivy Municipal High Income Fund, which takes a low-volatility approach to the sector, continues to be one of the top performers in its category, ranking No. 1 in annualized performance for the one-year, three-year and five-year periods, according to Morningstar.

Dan Moisand, principal of Moisand Fitzgerald Tamayo LLC in Melbourne, Fla., has been telling clients, "This is not a time to be fearful and don't be afraid to buy good quality muni bonds.

"The advice is basically: Let the people with poorly diversified or with at-risk issues do all the freaking out they want," says Moisand. "If we don't get caught up in that, we have reliable tax-free income to enjoy and possibly can get more for a good price."

Advisors Jon M. Larsen and Owen Murray are also telling clients to stand pat. Larsen, a portfolio manager at Albion Financial Group in Salt Lake City, offers clients the option of substituting a portion of their muni holdings with dividend paying stocks.
"While municipals still offer more stability," says Larsen, "with careful selection a client may have a greater after-tax yield with dividend stocks, coupled with the additional benefit of a buffer from some of the uneasiness found in the municipal market today."

"The trouble in the muni market is a lively topic among many of our clients. Our advice is to stay put and stop worrying," says Murray, a CFA and director of research at Horizon Advisors LLC in Houston. "We feel that a meltdown in the muni market is very unlikely, and that the recent pressure on prices is more of an opportunity than a source for concern."

Meanwhile, Rezny Wealth Management, headquartered in Naperville, Ill., is advising clients to avoid long-term muni bond holdings, but not sell out of muni positions entirely, according to Brian C. Rezny, the firm's president. He expects interest rates will rise over the next several years.

At the other extreme is Ted Feight, owner of Creative Financial Design, with offices in Lansing, Portage and Southfield, Mich., who has pulled clients out of all bond holdings, except those that come due this year, citing the likelihood interest rates will rise.

Bruce W. Fraser, a financial writer in New York, is a frequent contributor to Financial Advisor. He is writing a book on millionaires. You may contact him at [email protected]. His web site is www.bwfraser.com.