It’s hard to miss the dramatic headlines describing municipal bond prices lately; “slide,” “stampede” and “tumble” seem to be the expressions in vogue. But for investors willing to plumb deeper into the story behind the attention-grabbing headlines, they will find that the usual suspects behind most selloffs are missing, and the real story will once again be a boon for opportunistic investors.

The selloff in municipal bonds this month has resulted in an increase in yields by more than half a percentage point on high quality, long-term munis.

The reasons most often cited by the misguided financial media are the retreat of the Treasury bond market, presumably due to inflation fears, and growing concerns over municipal bond credit quality.

Enter QE2

Because long-term treasuries were excluded from the Fed’s buying binge, 30-year bond yields ratcheted higher and prices plummeted.

In a knee-jerk reaction, municipal bond fund investors, expecting muni yields to follow, began redeeming their shares en masse. The weekly net outflow of investor funds totaled more than $3 billion;  the highest level of redemptions since the fourth quarter of 2008,  the height of the financial crisis.

To accommodate these redemptions, fund managers were forced to dump their municipal bond holdings into the market without regard for price.

The most significant factor however – once again overlooked by the media – was the altered perception that the Build America Bonds (BAB) program, which market participants previously believed would be extended past the Dec. 31 deadline, would be allowed to expire. The thinking is, the program was never a favorite of Republicans, who may attempt to derail this part of the Obama administration’s stimulus program. As a result, municipal issuers have been intent on forcing all of their borrowing into the municipal calendar before year end.

Put simply, the municipal bond market, whose chief dynamic is supply and demand and is supported primarily by individual investors, could not handle this deluge.

Bond investors should be aware that these are short-term factors and not a long-term change in fundamentals.

Don’t fight the Fed

Ironically, while the media is screaming about inflation, the Fed is embarking on a new round of Treasury buying, known as QE2, designed to combat deflation, which it considers a more likely scenario. Inflation continues to be muted, with no change in sight. Aside from gasoline, prices were flat in October, and the “core” Consumer Price Index, which excludes food and energy prices, is up only .6% from a year ago – the lowest yearly increase since the CPI was first measured more than 50 years ago.

With high unemployment, lack of income growth and a troubled housing market, inflation doesn’t appear likely to be an issue anytime in the near future.

S&P, Fitch: Credit risk overstated

As for muni bonds themselves, Standard & Poor’s and Fitch recently issued two new reports indicating continued confidence in the ability of state and local governments to pay their debt on time.

According to Fitch, “as a class of debt, tax-backed credit remains strong, and that while the incidence of default may increase from exceedingly low historical levels, defaults will continue to be isolated situations.”

The financial talking heads, recently attracted to the bond market by the “headline hysteria” but not versed in government finance, have predicted otherwise and will continue to be proven wrong. Rating agencies may have taken their lumps in the mortgage-backed security sector, but they have consistently been closer to the mark when it comes to analyzing state and local debt.

According to S&P, the current financial crises that many governmental entities are faced with will result more in political fights over tough financial decisions than potential bond defaults. Debate in state legislatures and city halls is about meeting statutory balanced budget requirements, not whether to meet debt-service obligations. The agency’s report notes that revenue declines would need to be double the amount experienced in the Great Recession to cause more than sporadic bond payment defaults.

How investors can profit

It is difficult to overstate the psychological effect on the market from hysterical cries by outside observers on the credit risk posed by state and local governments. A weak economy does, to be sure, pressure government finances, but fear far outstrips the likelihood of massive defaults.

Fundamentally, nothing has changed in the past several weeks to justify the selloff. What it has done, however, is create exceptional buying opportunities in long-term municipal bonds, just as it did in 2008 after the Lehman Brothers bankruptcy.  Rather than bemoaning the drop in value of their holdings created by that “panic”,  investors who took advantage of the higher yields have continued to be rewarded.

A similar approach will prove profitable today, although in our opinion, this window of opportunity will be shorter lived.

Consider this: For investors in the highest tax bracket (35%), a high quality tax-free bond yielding 5.50% is equivalent to a taxable return of 8.46% even without factoring in state taxes.

Remember, tax-free bonds are purchased for the income.  Keep your interest clock ticking.

James A. Klotz is the President of FMSbonds, Inc. Email the Author11/19/2010