For some months now, the municipal bond market has been in turmoil over the possibility that multiple issuers could default on their obligations. Much like how the mortgage-backed bond market cracked and then shattered, spreading chaos throughout the credit markets, the worst-case fear is that there could be a cascade of defaults throughout the country. These defaults would not only be serious for those who depend upon municipal bonds to fund some portion of their retirement needs, but also for the states and state-sponsored agencies that depend upon the muni market for capital. (For a little background and history of this market, check out Fatal Seduction Of The Municipal Bond Insurers.)

Moreover, just as the collapse of the mortgage-backed bond market spread far beyond the debt markets and into the stock markets and economy at large, so too is the fear that a wave of muni defaults will rattle the economy and stocks once again. With all of the worry and anxiety, then, investors have been selling out of these bonds, pushing yields to two-year highs.

The question, though, is whether equity investors need to really worry about how the muni market may influence their portfolios.

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Why Worry?
As the housing bubble fell apart and the recession began, it became apparent that many states had worked themselves into unsustainable positions. As rising home values pushed up property tax receipts, many states made spending commitments predicated on the idea that the levels of tax revenue they were seeing was a "new normal."

When the bottom fell out, many states found that they were suddenly facing gaping deficits. Making matters worse, severe losses in their portfolios left a significant hole in the pension funds of many states and, while these unfunded liabilities do not always show up in state debt statistics, they nevertheless represent significant potential claims on state revenue.

Unsustainable Debts?
How bad is the situation? According to Moodys, states like Illinois and New Jersey are looking at long-term liabilities making up more than 13% of GDP and over 200% of the state's revenue. The fear, then, is that some states and municipalities may be approaching a point where they simply cannot afford to continue servicing their debt obligations.

Meredith Whitney has been among the most notable prophets of doom. A former sell-side analyst who predicted widespread trouble for money center banks in the fallout of the housing bubble, Ms. Whitney has floated the notion that there could be between 50 and 100 municipal bond defaults, representing hundreds of billions of dollars in principal value. Adding more gasoline to the fire, some politicians have begun to openly discuss the idea of allowing states to declare bankruptcy and many fear that is prelude to a wave of defaults.

3 Trillion Dollar Catastrophe
Certainly there is reason to worry if the muni market cracks. It is a $3 trillion market, and one long seen as among the safest and most conservative. At a minimum, a wave of state defaults would badly shake investor confidence and would likely force investors to reexamine their basic assumptions about the strength and sustainability of the economy. Trouble in the muni market would also be a major problem for the bond insurers - companies that took a furious pounding from the mortgage catastrophe. (Check out The Basics Of Municipal Bonds.)

Beyond that, though, many states rely upon ongoing access to the municipal bond markets to fund a variety of infrastructure projects. Without those funds, these projects may grind to a halt. That, in turn, would not only cost jobs in the short term, but the ongoing degradation of infrastructure would present a long-term problem for workers and companies in almost every sector.

Why Not To Worry
To some extent, the fear around the municipal bond market is not all that much different than the fear that surrounded the commercial real estate market and the commercial mortgage-backed securities market in 2009 and 2010. There were fears of widespread defaults among the numerous highly-leveraged real estate firms, and that the cracking of this market would once again freeze the credit markets, rattle the stock markets, and send the economy spiraling down again.

Despite the constant drumbeat of fear, it never happened. There were some defaults in real estate debt, some bankruptcies, and likely plenty of white knuckles and sleepless nights. And yet, the real estate debt market never fell.

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BABs Role in the Fall
Investors should also realize that the recent sell-off is not exactly all that it seems. A significant part of the decline can be tied to the decline in Build America Bonds (BABs). Like many government-sponsored idea, the BABs distorted the market (both for good and for bad), and the revaluation of these once-hot bonds has certainly fueled some of the overall muni decline.

It is also worth remembering that municipal bond defaults are not as cataclysmic for investors as something like a corporate bankruptcy. Debt payments would be restructured, repayment schedules would be extended and investors might not get the interest they were expecting, but it would be extremely unlikely that they would lose their principal entirely. Moreover, since most wise muni investors buy for the coupon and hold to maturity, the ups and downs in the meanwhile are sometimes little more than noise. (For more see An Overview Of Corporate Bankruptcy.)

Investors should also remember that municipal bond markets are local markets to a large extent. In other words, Massachusetts and Connecticut may be facing some difficulties, but states like Nebraska, North Carolina and Indiana would seem to be in much better shape. So although it is true that major states like California, Illinois and New York have above-average influence and significance because of their size, it is hardly a nationwide catastrophe.

The Bottom Line
There is no doubt that many states in the U.S. have spent and promised themselves into difficult, if not untenable, situations. Moreover, if municipal bond issuers get the option to declare bankruptcy and restructure their obligations, it would not be all that surprising to see a small-scale replay of the European debt crisis of 2010. That is, state residents may ask their politicians why they should have to accept higher taxes and fewer government services just so that the state can keep making interest payments to "rich out-of-state Wall Street types."

The worst-case scenario of mass defaults seems improbable, though. True, some states are at a precarious point and may have little choice but to raise taxes and cut services, likely spelling bad news for the economies in those areas. But that hardly means default is imminent, nor that its a nationwide problem. Though it may not be appropriate for inexperienced investors to go blindly bargain-hunting in the muni market, equity investors should watch these developments with interest and not panic.

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