For those of you unfamiliar with Meredith Whitney, let me give you a short history. Back in 2007, Whitney was a relatively unknown analyst for Oppenheimer, when she wrote a particularly scathing report on Citigroup, a report that would later prove as being accurate. She started to gain popularity, appearing on all the major U.S. business channels regularly, eventually leaving Oppenheimer in 2009 to start her own firm.

More recently, Whitney was on 60 Minutes in December of 2010, where her pessimism switched focus to the American municipal bond market. She predicted upwards to 100 defaults in 2011 alone, a far cry above 2009 where there was only 10, and none of those were very big. If Whitney is right, municipalities could default on hundreds of billions of dollars on debt.

Historically, muni bond defaults have been extremely rare. Between 1970 and 2009 there were 18,400 bonds issued, with only 54 of them defaulting. During that time Americans had to deal with fuel shortages, out of control inflation, huge deficits, a dot com bust, more than one stock market crash, and a massive housing meltdown. Throughout all that, just about every municipality paid their debt obligations. The nice thing about lending governments money is they have the ability to control revenues by increasing prices or taxes.

Let’s Back Up: Basics Of Muni Bonds

When a municipality needs money for some sort of huge capital project, they need to tap investors to get the capital needed. The city will go to the market, where mostly institutional investors will each pony up some of the capital needed until the town gets the money they need. Like any bond, the municipality just pays interest until the bond comes due, where investors will either demand repayment of their original investment or they will accept a new bond in lieu of repayment.

The American government wants to encourage individual investors to buy some muni bonds, so they make any interest received by individual investors tax free. Therefore, a 3.5% yield on a muni bond is more like a 5% yield on a comparable, taxable bond.

Canadian investors may not be familiar with muni bonds. In Canada, we don’t enjoy the same tax breaks as American munis do. Our muni bond market is almost exclusively the domain of institutional investors and pension funds. As far as I know, individual investors can buy some of the larger issues, but the market isn’t nearly as well developed as the Americans.

Insurance? Yes Please

Most muni bonds are insured by two publicly traded companies, MBIA and AMBAC. For a small one time payment, municipalities can buy protection just in case they’re ever forced to default on their bonds. Like any insurance company, MBIA and AMBAC pocket the premium, invest it, and hopefully never have to pay out a dime of it. If they do, the hope is they’ve invested the money wisely enough so they have enough to fulfill their insurance obligations.

If 50 or 100 municipalities default, both of the big insurance companies would be overwhelmed with insurance claims and would go bankrupt, just like what happened with AIG in 2008. If that happens, speculation is that the U.S. Government would then step in and bail out the affected insurers.

Time To Buy?

In the fourth quarter of 2010, muni bond funds were down 4.7%- which doesn’t sound like much on the surface- making it the worst performing quarter for muni funds since 1994. In January so far the funds have continued to sell off, with a small uptick in the last few days.

The way to play muni bonds is to buy one of the literally hundreds of ETFs and closed end funds that trade publicly. There’s a definite possibility that a few issues could blow up. If you’re investing in a fund that holds bonds from 200 different cities, you’re diversified enough to weather a few defaults. If you do decide to invest in an ETF or fund, take the time to read the prospectus and the top holdings. Buying something without a good idea how it works isn’t a good idea.

Two I Like And Might End Up Buying

I’m a big fan of the Dreyfus closed end funds, since they use a bit of leverage to enhance bond returns. A normal ETF of munis will yield about 5-6%, however DSM and DMF yield close to 8%, thanks to a 25% leverage position. They have diversified portfolios, with 80% of their holdings being rated A or above. A downfall is that both funds have a good portion of their capital invested in the California market, (25%) a market that is the lightning rod of the muni controversy. Basically, both funds are the same.

Both funds are diversified enough that if a new issuers blow up, the whole fund isn’t screwed. As always when leverage is involved, the potential for losses is escalated. If you hold the opinion that munis are a solid asset class and the blowups will be few and far between, a 25% leverage position is quite reasonable.

If you do buy these, make sure to buy them in your RRSP or TFSA. That way, you’re not hit with a nice tax bill every year from the interest.

Tell everyone, yo!