Much has been said about the municipal bond market during 2011. The year started with attention-grabbing forecasts for "hundreds of billions" of dollars in defaults as cities and states faced growing budget deficits and underfunded long-term liabilities. More recently, certain segments of the muni market had their credit ratings downgraded following the downgrade of the federal government.

Still, investors are recognizing the attractive valuations of those securities and the market for tax-exempt securities has stabilized amid steady improvements in municipalities' fiscal situations.

Considering the breadth of the municipal bond universe, general predictions about defaults or performance seem destined to be misleading. The market is about $2.9 trillion in size, includes about 50,000 separate issuers, and consists of several different types of securities. Indeed, about 75% of the municipal bond market consists of revenue bonds that are supported by revenues from specific projects, many of which are essential, such as water and sewer services. Because of the support from identifiable and often segregated revenue streams, these bonds are generally unaffected by budget difficulties or downgrades related to the federal government.

To be sure, the segments of the muni market that recently had their credit ratings downgraded have direct ties to the federal government. Those 11,500 securities that were downgraded, however, consist of only a small part, about 1%, of the overall market.

Other securities in the municipal bond market consist of debt that has been issued by cities and states that have been far outpacing the federal government in terms of getting their financial houses in order. The fact that cities and states are leading the way in regaining their fiscal health is primarily a function of the law—49 states and many cities are legally required to balance their budgets. The steps that these entities have taken are often difficult because they include reduced services, employee layoffs, and higher benefit contributions. Although difficult, these steps include not only current budgetary savings, but they also begin to address municipalities' long-term issues regarding underfunded retiree pension and health care plans.

Meanwhile, municipal revenues also have been increasing. The first quarter of 2011 marked the sixth consecutive quarter in which revenues at the state and local level have increased, according to the U.S. Census Bureau.

While increases in revenue often come from higher taxes, municipalities have resorted to some innovative ways to generate additional revenue. For example, natural gas discoveries through the process of "fracking"—that is, fracturing shale deposits to release trapped gas—have been an economic boom for many municipalities. Several states, including New York and West Virginia, collect fracking fees or taxes. In West Virginia, this tax amounted to nearly $53 million in the fiscal 2011. And Pennsylvania is considering such a tax.

As municipalities have reduced spending and raised revenues, investors may be comforted by the fact that the default rate in the municipal bond market has been steadily declining. Municipal bond defaults during the first half of 2011 totaled $746 million, or 67% below the $2.3 billion in defaults in the first half of 2010, according to Bloomberg. For further comparison, there were a total of $6.3 billion of defaults in all of 2009 and $8.15 billion in defaults during all of 2008.

Taxes No Sure Thing Here
In addition to a historical default rate that is far lower than that of corporate bonds, a primary benefit of municipal securities is that they are exempt from federal income taxes. And if investors purchase securities within their state of residence, the income from municipal bonds may also be exempt from state and local taxes.

But even before the tax treatment is factored in, the yields on 'AAA' municipal bonds of all maturities were more than 100% of the yields on Treasury securities with similar maturities, as of mid-August, according to Bloomberg. This was after the ratings downgrade of U.S. debt by Standard & Poor's.

When considering the tax-equivalent yield—or the pretax yield that a taxable bond needs to be equal to that of a tax-free municipal bond—the potential value in municipal bonds is enhanced further. For example, an index of municipal bonds with maturities of 22 years and longer and an average credit rating of 'A1,' yielded 4.80% as of mid-August, or a taxable-equivalent yield of 7.4% for investors in the highest income tax bracket. Meanwhile, a 30-year Treasury bond rated 'AA+' had a taxable yield of 3.6%.

The examples above also demonstrate the historically steep yield curve in the municipal market, which has been driven by the Federal Reserve's policy for a fed funds rate of near zero. This has led to an environment in which investors may pick up a substantial amount of yield by moving further out on the curve. For example, an investor could gain an additional 1.53% in yield by moving from five-year 'AAA' rated securities to similarly rated bonds with 10-year maturities.

Investors may take a similar approach by assuming more credit risk in securities with lower credit ratings. A 10-year GO [government obligation] index of 'BBB' securities had a yield of 4.08% in mid-August, or a tax-equivalent yield of 6.28% for investors in the highest tax bracket. This compares favorably with an index of 'BBB' rated corporate bonds that yielded 4.05%.

After all the media hype about the potential for defaults among municipal securities, it seems that, in general, they have been able to do what the federal government has not: balance their budgets. And many states and municipalities have gone further to address their long-term liabilities. Still, fears of defaults and worries over downgrades have kept many investors away from the tax-exempt sector, which helped create an opportunity that compares favorably with other fixed-income options. It seems that a diversified portfolio of well-researched municipal securities could capture the relatively attractive return investors are seeking in a yield-starved environment.

Zane E. Brown is a partner and fixed-income strategist at Lord Abbett

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