But there's a flip side: According to Larkin and other experts, while the recent muni bond sell-off might signal investor unease—muni bond funds shed almost $7.6 billion in November 2010 (the largest outflow since October 2008) after posting net inflows for the previous 22 months—it could also signal a buying opportunity for the more intrepid. According to Larkin, a large number of muni bond investors are high-net-worth retail investors looking for the tax efficiency muni bonds offer, but they are easily spooked. "They don't have as good of information to really analyze and know the municipality," he says. "People tend to oversimplify when they lack information."
That lack of information could cause skittish investors to try to unload their muni bonds, which would create a glut of supply. Mix in the low liquidity of the muni-bond market and you could have those bonds selling at a significant discount. "That's where the opportunity comes because people tend to sell the good stuff thinking that it's the bad stuff. If you're a long-term investor, it's probably not a bad place to start putting money." Buying opportunity or not, the worst thing investors can do right now could be to pull out of the muni market. "The panic is too generalized," says Early. "There are certainly some muni investors who should be panicking, but some people hear the word 'muni' these days and just sell and they're selling the good with the bad. The risk profile is different than it used to be, but that doesn't mean they're bad investments."
Despite all the uncertainty in the muni-bond market right now, one thing is for sure: Interest rates will eventually go up, and investors should be prepared. Whether the Fed starts the hike in 2011 or two years down the road, rising interest rates negatively impact bond prices. Moreover, since muni bonds tend to have longer durations, they court more interest-rate risk. "If you want safe money, no matter what you're buying, you want to focus on credit quality but you also want to look at interest-rate risk," says Thau. "I would say keep your maturities short, no more than five years, because if interest rates go up, the principal goes down significantly. Buy high-quality and keep your money short."
Lastly, the super-safe reputation muni bonds enjoy has certainly taken a hit over the past couple of months, but experts say investors shouldn't be scared away by overgeneralized reports of defaults and bankruptcies on a massive scale. "Historically, we have one of the lowest default rates, and even if that were to crank up, it's not likely going to impact the good quality parts of the municipal bond market, which is a big chunk of it," Larkin says. Especially if the economy continues to improve, however incrementally, tax revenues should start to recover giving municipal bond issuers a little more wiggle room when it comes to budgets and bond obligations. "Municipalities tend to run into the money issues at the opposite end of the cycle because they collect everything in arrears," he says, "So if you look at the past year, it was pretty much a disaster, but if you look out 12 months, a lot the these problems might end up going away themselves."