The latest debt scare making the rounds: Fear of widespread municipal bond defaults. We’ve all heard again and again the stories of state-government financial problems, so when a well-known doom-and-gloom strategist appears on TV warning about major problems in the municipal debt markets, investors take note and by taking note we mean they sell their municipal bonds.

Fund investors had been stuffing tens of billions a month into taxable corporate as well as tax-free municipal bond funds. This trend reversed with a sudden jolt in November - a month that investors withdrew $7.7 billion from muni bond funds. December was even worse with about $12.5 billion out the door. 

This combined $20 billion out in two months was a good chunk of the $32 billion that went in to muni bond funds from January 1st 2010 to the start of the withdraws in November. So far it looks like we’ll see another $10 billion or so come out in January 2011.

In 2009 $69 billion went into muni bond funds, so we still have a ways to go before all that money leaves. Still, December’s outflow was larger than the last big month of panic selling in muni funds on record, October 2008 were $8 billion flew out the door of muni funds. Big fund sales are almost always come shortly before buying opportunities.

We used the 2008 panic as reason to buy and added muni bond funds to our online portfolios for the first time at the end of October 2008. We had to endure a few months of wild swings in bonds and then closed-end muni bond funds we used recovered from significant previous losses. We were out of our muni funds by mid-2010. But keep in mind: In client accounts we use muni bond funds in a different way, not just because of relatively rare opportunities they offered all investors at the time but to deliver better after-tax returns. We don’t know the tax brackets of followers of our online portfolios so our use of muni bond funds is generally limited.

Will we use the recent slide in muni bond fund prices and outflows of investor money to get back in to municipal bonds? Probably. But not right away and not all at once. For one, the market price discounts closed end muni bond funds are trading at to actual fund NAVs are not as wide – indicating investor fear - as they were the last time we moved in.

First, a brief review of what has happened in recent weeks.

The muni-bond market started to dip along with longer-term US government bonds as interest rates started to move up this past September. Since many muni-bond funds are longer duration than corporate taxable bond funds and have the next lowest default risk after government bonds, they were going to take a hit when rates went up. In general longer-term, low-credit risk bonds get hit the hardest when rates go up.

Then the elections came in early November and the muni bond slide picked up steam as Republicans won by wide margins and a general deficit hawk mentality took over Washington. This slide was also partially the result of the Federal Reserve announcing a long term bond buying program which panicked inflation watchers but was more the result of expected changes to the federal government.

Of note were the extensions of the low Bush tax rates which are actually bad for muni bond prices. High income-tax rates lead to higher after-tax yields of tax-free bonds. If the government cut the top tax bracket to 10% tomorrow we’d see muni bonds slide (and yields go up) the same day.

There was also an expectation that cash from the federal government to states would dry up, increasing the troubles at the state levels.

This slide in muni bond prices only recently started to accelerate beyond what could be expected from a general rise in longer-term interest rates. The reason for this is pure unadulterated panic from all the fear mongering.

You can’t blame muni bond investors. They have seen this game play out a few years ago in supposedly safe AAA mortgage debt that proved to be about as safe as unsecured credit card debt. When prices start a-sliding investors head for the doors and ask questions later. We’re as guilty as the next guy, having sold some of our very limited current client muni bond holdings during the early stages of the drop. 

Muni bonds are a strange product. They are owned almost exclusively by ordinary individual investors (either directly or through mutual funds) – and much through leveraged closed-end funds. As they are priced by tax rates, they tend to be owned by those in the higher tax brackets. 

Muni bonds are issued by states but also by the thousands by local municipalities and to finance hospitals, stadiums, utilities, and a host of other projects. It’s not the most liquid market in the world. If muni fund investors head to the door fast you will see mandatory selling by all the funds to a world of few buyers. There will be limited support from hedge funds, foreigners, and value investors like we would expect to see in other panics (though recently some have noted California long- term bonds now yield more than some from Mexico and Columbia and can make sense for non-traditional muni investors as shorter term speculations).

This is the risk we worry about, and want to eventually profit from: panic selling and ensuing low prices from the run for the exits for what is essentially a low risk investment. We’re close. It’s possible, even likely, we won’t see a real panic in munis. There are some very rich individuals in high brackets who can do much buying to offset the sales by the mere ordinarily rich, people like Bill Gross of Pimco who put some more of his own hundreds of millions into muni bonds. Many of these investors have a much higher tolerance for risk than more typical muni bond investors.

Muni bonds are owned for the low-risk and stable returns. Few who own them want to see another few weeks of 10%+ slides in muni bond prices. If they wanted that kind of risk they’d own high dividend yield stocks. It’s a market that could panic, especially with all the scary talk going on. The fact that investment grade municipal debt has ultra-low default rates, generally under 1% and currently under 0.2% for the higher grades of debt, and has a pretty good recovery rate (how much an investor gets back after a default or missed payment) in default – both default rates and recovery rates higher than similar corporate bonds, which are seeing no real panic selling.

We like the long term after-tax returns in munis. Aging baby boomers won’t pass up the 5%+ tax-free yields for stock market risk and sub 2% yields (albeit a growing dividend yield) for long. But there may be more panic to come. 

Bottom line, we don’t fear the defaults, we fear the fear. For those who fear the defaults, consider what just appeared on my latest Connecticut power bill: a new tax to pay for the budget deficit. States may not have the money printing power of the federal government, but don’t underestimate their ability to raise revenues out of thin air before defaulting on their obligations, something corporations can’t often do when times are tough. This may not save a few hundred unrated or otherwise questionable non general obligation muni bonds out there, but it will keep 95%+ of the market in dollars performing.