Ryon, Gundlach and Whitely may have slightly different takes on whether municipal bonds are fairly priced. But they agree that the psyche of the municipal bond investor makes them uniquely vulnerable to a panic.
Unlike other fixed-income vehicles, 70% of municipal bonds are owned by individuals, either directly or through mutual funds. Moreover, one-third of all closed-end funds are muni funds.
Many individuals, including millionaires and billionaires, invest their entire fixed-income allocation in munis. "They are not thinking about diversification; they are only focused on tax avoidance," one observer remarks. "They own munis for the wrong reasons and if there is a steady stream of negative headlines they will have trouble sleeping at night."
It's that kind of scenario that has Gundlach predicting that, if muni investors freak out, the panic could initially take the good bonds down with the bad. If bond prices drop 15% to 20%, closed-end funds might get completely slam-dunked and trade at big discounts to net asset values. That's why he's keeping his powder dry and waiting.
Were a raft of municipal bonds to actually default in the manner Whitney depicted, Gundlach acknowledges it would shock the entire financial system. "If the muni market blows up, it would affect everything," he says. "Defaults would clearly be a negative for consumers." But he suspects it will require much less to turn the muni market into a bargain basement.