Muni Bonds for 2012?

Is it too late to get on the muni bandwagon? Municipal bonds, one of the more sleepy corners of the investing landscape, outperformed commodities, corporate bonds, Treasuries and even stocks last year. Is there still an upside left in 2012?

The Fall of the Muni

Before we look forward, let’s back it up a bit. Muni bonds did so well last year in part because they entered 2011 beaten down. Meredith Whitney, a Wall Street analyst, spooked the market at the end of 2010 when she predicted that 2011 would be a terrible year for the muni market. She said on CBS’s 60 Minutes that, “The year would see 50 to 100 ‘sizable’ defaults followed by several downgrades of major municipal securities.”

The dire prediction sent muni bond prices down, pushing muni bond yields, the interest the bond pays you per year, up. Note: Bond prices and yields move inversely. That means that state and local governments had to give a higher interest rate to attract investors.

The Rise of the Muni

As a result of Whitney’s call, the muni market remained depressed for the first half of the year, but by June it was becoming clear that the sky was not falling. The total value of muni defaults in the first half of the year was $511 million, a third of what it was the previous year. That $511 million may seem like a lot of money, but that is out of a total market worth around $3.7 trillion.

When investors noticed that the market was doing well, they began dog piling in. Prices for muni bonds shot up, while yields fell. That means that investors were now getting less interest for the money they invested. Those investors brave enough to buy muni bonds in December 2010 averaged a rate of return of around 10.5% on the year.

Are Munis Safe Investments?

Munis are overall safe investments. While some might fail, the vast majority will remain solvent. Most of the state and local governments that Ms. Whitney thought would default on their obligations reversed course last year by raising taxes and cutting spending. It turns out that state and local governments will do almost anything to avoid a trip to the bankruptcy court.

Average yields for high-grade muni bonds ended last year at their lowest rate since the 1960s just below 2%. So, are muni’s still worth it?

While the market almost certainly won’t do as well as last year, muni’s are still worth it for those seeking a very safe investment. The key with muni’s, unlike other investments like corporate bonds or stocks, is that many are tax exempt. That means capital gains and personal income tax will be not be levied on your returns. So ,while the yield seems low, it is actually much higher when you factor in taxes.

There are a lot of options for you if you want to invest in a muni bond. In fact, there are over 60,000 different muni bonds for you to choose from in the US, each with their own specific investing dynamic. Muni’s that have lower credit ratings usually have higher yields, but the price for that extra yield comes in the form of a higher risk of default.

Predictions for 2012

State and local governments are expected to increase the amount of new muni bonds issuances this year, so there will be plenty of choices for you if want to get in the game. Since muni’s will be yielding, on average, single-digit returns, this investment is a great alternative for people who would otherwise buy a certificate of deposit or a US Treasury bill. Those investors that just park their money in their checking account are also good candidates for muni’s. While the muni market probably won’t be as exciting as last year, for many of us, they are still worth taking a look at.

Cyrus Sanati is a frelance financial journalist whose work has appeared in dozens of leading publications, including The New York Times, BreakingViews.com, and WSJ.com. Follow Cyrus on Twitter @csanati.