It's hardly surprising that Detroit's insolvency—the largest municipal bankruptcy filing in U.S. history—should have rocked the muni bond market. After all, one of the reasons that these securities have become such a core part of investors' portfolios is that bankruptcies are so uncommon, allowing the $3.7 billion market to remain a relatively calm haven.
Now, however, investors are reacting to the news from Detroit as if the rest of the muni market also is circling the drain, as star analyst Meredith Whitney predicted would happen only a few years ago.
Some other Michigan communities have had to withdraw or postpone their own planned debt offerings: Potential investors in a proposed $53 million offering of a kind of general obligation bonds by Genesee County wanted higher yields than the county was willing to offer, while the city of Battle Creek has said it will postpone its own $16 million offering until the market isn't imposing a de facto tax on any new Michigan debt offering.
That's the problem in a nutshell. In good times, investors are prone to bidding up the value of all kinds of muni bonds, only to recoil from the asset class as a whole in the wake of a headline reminding them of the risks.
Right now, we appear to be in the midst of another such flight: In the week ended July 31, muni debt funds witnessed outflows of $2.2 billion, their 10th straight week of net sales, according to Lipper data. Coming on top of the ongoing anxiety about the timing and extent of a "tapering" of the Federal Reserve's $85 billion monthly bond buying program, Detroit's bankruptcy filing was too much for investors' nerves to withstand, it seems.
Still, muni bonds haven't lost any of the characteristics that make them alluring to investors. They continue to offer a cushion against stock market volatility; even in the general selloff in May and June, muni bonds lost less ground than did stocks. For many investors in many kinds of securities, munis offer tax-free income. Ditching them from your portfolio out of fear may be—cliché alert—a bit like tossing the baby out with the bathwater.
That doesn't mean that you shouldn't be discriminating, however. While the asset class may not be as risky as the headlines imply today, not all muni bonds are created equal. It has long been conventional wisdom among professional investors and financial advisers that you should gravitate to bonds whose interest payments are backed by revenues from such essential services as water or sewage systems, rather than general obligation bonds tied to property tax revenues. No homeowner wants to go without water.
(Read more: The decision with trillions on the line)
Six muni market myths
BlackRock's muni bond investment and research team has just published a handy guide to life in the aftermath of the Detroit bankruptcy, highlighting six myths that still govern the market:
1: All municipal issuers and credits are created equal.
2: Distressed cities are a major part of the municipal market.
3: Detroit is a domino.
4: Distress necessarily leads to Chapter 9.
5: Pension problems are set to sink the municipal market.
6: The municipal market is in trouble.
The first myth, as noted above, is that all issuers and credits are created equal. Clearly, that's not the case. For instance, unless you've got an overdeveloped tolerance for risk, you may not want to snap up bonds issued by the city of Chicago in the wake of the big downgrade in credit quality by Moody's Investor Service last month. The city is still on credit watch with a negative outlook, thanks to the outsize municipal pension liabilities. But with 95,000 issuers out there, not all are going to be grappling with the same problems as Chicago, Detroit or Jefferson County, Ala., which is reorganizing under bankruptcy protection. Even those that face problems operate in different legal and regulatory jurisdictions. In other words: due diligence matters.
Myth No. 2, the folks at BlackRock tell us, is that many or most muni bond issuers are distressed. Nope. Moody's says only 34 of the 7,500 entities whose debt it rates have a rating that is below investment grade; the other 99 percent are doing well. Moreover, BlackRock suggests that the trouble spots can be identified: Moody's sent out the first warnings about Detroit's plight four years ago.
(Read more: Detroit worries municipal bond owners)
Nor is Detroit necessarily a domino, with its bankruptcy about to trigger a flurry of similar filings. (Take comfort, Battle Creek bond investors.) Detroit has battled long-term structural problems, cursed with ineffective or corrupt city leaders and a lack of support from the state. Other cities have done better by rebuilding their tax bases and successfully increasing their population: Pittsburgh, for instance, despite being another post-industrial economy, just had its debt upgraded by Moody's.
"The market's underlying fundamentals are very strong," conclude the BlackRock muni market analysts. "State revenue collections have risen for 13 consecutive quarters while spending is declining; housing markets are improving … and state budgets are being passed on time."
Clearly, BlackRock has a vested interest in keeping us all from panicking and fleeing the sector: Its vast array of investment products include muni bond mutual funds and ETFs. Nonetheless, the arguments it is putting forward clearly are based not only on logic but on the available data.
By all means, toss out the bathwater. But hang on to the baby.