Christine Thompson, chief investment officer of the bond group at Fidelity Investments, and her team of municipal bond fund managers are closely watching a potential bankruptcy in the health care sector. This is not because they own bonds in the company on the brink but because of the impact a single bankruptcy could have on the rest of the industry.
“The muni market will have land mines that explode,” Ms. Thompson said Tuesday at a Fidelity chief investment officer round table in New York. So the question isn't whether or not there are some bad apples in the municipal market, it's what effect they will have on municipalities that are well-managed, she said.
The worst-case scenario is a repeat of the liquidity event — or, more precisely, the lack of liquidity — that took place after muni analyst Meredith Whitney predicted massive defaults in 2010.
That prediction sparked a wave of redemptions across the municipal bond fund market, forcing fund managers to sell their holdings into an illiquid market and causing the funds' performance to turn negative for a four-month span from November 2010 to February 2011.
Several high-profile bankruptcies could cause a similar freakout among municipal bond investors, which are primarily retail investors.
Further complicating the outlook for the municipal market is the possibility of Congress' taking away a chunk of the tax-free income the bonds provide as part of a fiscal cliff compromise.
“We're worried about another liquidity event because of the herd instinct of investors,” said Ms. Thompson, who ran Fidelity's municipal bond group from 2002 to 2010.
Fidelity's municipal bond funds currently are keeping their funds' liquidity in sharp focus so they won't be forced to liquidate holdings to meet redemptions should there be another exodus.
Despite these worries, there is a huge bright spot for investors who can stomach some volatility.
“There could be some blanket reactions in the short term, but that offers long-term opportunities,” Ms. Thompson said.
In fact, municipal bond fund investors have the mini-panic of 2010 partially to thank for the category's stellar returns over the last two years. The forced selling created bargain prices that strongly rebounded. In 2011, municipal bonds had just over a 10% return, trailing only Treasuries as the top-performing asset class for the year. This year, the category has returned another 6%.
The bonds aren't currently priced to repeat those returns, Ms. Thompson said. But if there's a dislocation in the municipal market because of forced selling, that could change.