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.