Muni bond market a big winner as stocks dive

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Turns out it was a good idea to keep the faith in tax-free municipal bonds last winter when so many investors were bailing out.

It was an even better idea to buy more munis at that point.

While the stock market has dived this week investors have been bidding up the value of many muni bonds, apparently hungry to lock in tax-free yields.

That demand has pushed muni market yields sharply lower, in tandem with the steep decline in yields on U.S. Treasury bonds.

The annualized tax-free yield on the Bond Buyer newspaper’s index of 40 long-term muni bonds nationwide (charted below) sank to 5.02% on Thursday, down from 5.07% on Wednesday and the lowest since Nov. 8.

It was early last November that the muni market was slammed by a sell-off that lasted into January. The selling, spurred in part by deepening worries about the health of state and local government finances, was egged-on by Wall Street banking analyst Meredith Whitney.

In late-December Whitney made a now-infamous prediction that ‘hundreds of billions of dollars’ of municipal bond debt would end up in default in 2011 as local-government finances crumbled.

As frightened investors dumped munis, particularly muni mutual funds, bond prices tumbled and yields rocketed. The yield on the Bond Buyer index reached a two-year high of 5.95% in January.

But the wave of defaults never came -- or at least, it hasn’t yet. Meanwhile, muni bond issuance is down sharply this year as state and local governments have curtailed borrowing.

The result: The muni market has been rallying steadily since mid-April. That shows up in share prices of popular muni bond funds.

Shares of the Franklin California Tax-Free Income fund have risen from $6.51 in mid-April to $6.97 as of Thursday, a gain of 7%. The price has jumped 10 cents a share, or 1.5%, just this week.

Year to date the fund’s total return, meaning share price gain plus interest earnings, is 6.9%. That beats the returns on many taxable bond funds. The Pimco Total Return fund is up 4.5% this year.

Interestingly, the muni market hasn’t been shaken this week despite two high-profile examples of exactly the kind of trouble Whitney warned about: The town of Central Falls, R.I. filed for bankruptcy protection, and Jefferson County, Ala. is considering doing the same.

For her part, Whitney is unrepentant. She continues to assert that muni investors are underestimating the severity of state and local governments’ funding shortfalls for employee pensions and health-care benefits, and how that could end up hurting many bond holders.

But so far this year, the big hurt has been on the investors who rushed to sell munis when bond prices were cratering in January and yields were soaring.

-- Tom Petruno