Though fears of a financial armageddon have come and gone, the municipal bond market still faces dangers due to the continued global debt crisis and tougher conditions closer to home.
Munis have held up well this year, thanks to a variety of conditions: Low supply, municipal government belt-tightening and a national economy that appears, for now, to have skirted past fear of another recession.
But those conditions may merely set the table for darker things to come, as austerity eats into growth potential, the state of the economy remains in flux and debt and deficit problems intensify.
"There's going to be lots and lots of screaming," says George Friedlander, senior municipal securities strategist at Citigroup. "The ability to provide basic services is impaired and that's going to mean lots and lots of battles between governments and public employees, and those will be played out in the press. They will make some investors nervous."
Nevertheless, Friedlander doesn't expect to see the waves of defaults predicted late in 2010 by analyst Meredith Whitney, whose public proclamations spooked the markets and generated a whipsaw selloff into the early part of 2011.
"We're going to see a handful of middle-sized or smaller communities have true credit crises, but only a handful," he says. "We are going to see more downgrades, particularly in single-A (general obligation) on down. But still a very, very limited number of defaults."
Barring anything dramatic happening in the next two months, Whitney's prediction that up to 100 major defaults would occur, generating more than a $100 billion in damages in the $3.7 trillion muni market, has virtually no chance of materializing this year.
The wild card, of course, is the European debt crisis. Though the European Union's debt accord on Thursday staved off a crisis for now, the region is far from being out of the woods. Should sovereign debt defaults escalate and Europe goes into recession, contagion is likely to spread and impact the muni market, though it's too early to say by how much. Even then, the major triggers probably wouldn't be released in the US until 2012.
"How does 2012 look? Not as good," says Peter Coffin, who manages $13.5 billion of assets as president of Breckinridge Capital in Boston. "Is the market vulnerable to more selloffs? Absolutely. Demand remains thin. That imbalance and mismatch of supply and demand persists. Credit fundamentals looking ahead are going to be more of a challenge."
There have been about 145 defaults so far this year, but the total dollar loss has been a comparatively benign $1.28 billion. Most of the defaults, such as the ones from Harrisburg, Pa., and Jefferson County, Alabama, were fairly well telegraphed and generated little movement from the muni markets.
Overall, municipal bonds returned 8.94 percent through the first three quarters, including a 3.95 percent third-quarter rate, according to Standard & Poor's. High-yield munis — which are the riskiest government offerings — have returned a stellar 9.55 percent.
Still, some believe Whitney performed a service by calling attention to the urgency for local and state government spending reform, even if she overstepped by making a muni call while her milieu is banking analysis. Whitney declined comment for this report.
The Whitney call was akin to testing a house's foundation and finding it weak, Coffin says.
"Last year Meredith Whitney deliberately, and I would say responsibly, walked up to the house and kicked it and the house fell down," he says. "Is that Meredith Whitney's fault? Yeah, she shouldn't have made these outrageous predictions that had very little basis and betrayed a poor understanding of municipal finance.
"But structurally there was probably a problem there as well. This market is still not in balance. It's a retail market and for years the capital needs and issuance exceeded or was just a poor match for the demand."
The supply-demand equation has come more into balance this year as debt-averse governments haven't brought as much product to the market. That keeps yields lower and prices higher as investors looking for muni exposure cannot demand better rates.
Issuance for 2011 has come to $209.9 billion as of Oct. 19, a decrease of 5.6 percent from the same period a year ago, according to Bank of America Merrill Lynch. The firm believes its projection of $245 billion for the year will be met and possibly surpassed by up to $15 billion.
"The muni market has had a decent year because of one and only one thing: Low supply," says Marilyn Cohen, president of Envision Capital Management in Los Angeles. "The demand continues to be there, the supply continues to dwindle."
At the same time, Cohen acknowledges that government belt-tightening also helped restore faith in munis, something particularly important as states face a total $4 trillion debt liability.
"They are doing the right thing with cutbacks on personnel," she says. "They are making bond holders the top priority because they don't want to be shut out of the muni market. But I ask rhetorically, how long can that go on?"
Indeed, austerity, necessary though it may be, has drawbacks.
Running finances so close to the bone can be seen by investors as a disincentive to growth which adds uncertainty to the future ability to meet debt payments.
"There was good political resolve to tackle long-term structural issues, some pretty meaningful strides in terms of pension reforms and retiree health care across a lot of states," Coffin says. "Austerity was hip. (New Jersey Gov.) Chris Christie — everybody followed his lead."
So there are few in the market who believe that Whitney's predictions will ever come true, despite the clouds forming ahead.
Still, most strategists are warning clients away from high-yield, despite how well the group has held up this year, and directing towards higher quality and medium duration. The seven- to 12-year part of the yield curve , for instance, has substantially outperformed both the three- to seven-year and 22-plus year issues.
Citi's Friedlander says he is "not a big fan of smaller, local governments in areas of clear economic pressure," instead preferring central service revenue bonds.
Issuers with the widest spreads over 10-year Treasury bonds are Puerto Rico, Illinois, California, Michigan and Nevada. Friedlander does not necessarily recommend against investing in those regions, but advocates staying with higher-quality areas.
Coffin's firm normally stays in the five- to seven-year maturity range but has used an uptick in rates that came with an increase in supply to go a bit further out to 10-year notes. Specifically, he has been buying state and local government debt in Michigan.
Similarly, Cohen says she's staying high in quality, in particular buying bonds related to airport, water and sewer revenues. She worries about the so-called "super-downgrades" that have taken some issues down several notches, but still does not sense a major market collapse in the air.
"It won't be surprising to see municipal downgrades a lot this year and next year, certainly for some of those entities and issuers that were just holding on for dear life," Cohen says. "But I don't anticipate armaggedon — more of a tough haul here."