The municipal market’s biggest July decline in a decade is leading investors such as Vanguard Group Inc. to bet history is on their side as they buy with yields close to a two-year high.

Tax-exempt debt fell about 1 percent in July, the worst performance for the month since 2003, Bank of America Merrill Lynch data show. If the past is any guide, the trend for munis is poised to reverse in August: Only once in the past 24 years has the market declined in both months.

Benchmark 10-year munis yield 2.91 percent. That’s about 112 percent of interest rates on similar-maturity Treasurys, where the average since 2001 is 93 percent. For Chris Alwine at Vanguard and Rick Taormina at J.P. Morgan Asset Management, which oversee a combined $135 billion in munis, the elevated ratio is a signal to add tax-exempt securities.

“Municipal bonds are relatively cheap, and we’re seeing people come in and take advantage,” said Phil Fischer, head of muni research at Bank of America in New York. “While this is typically a strong period for muni performance, this is not a strong year. Mutual-fund flows continue to be strongly negative and we had a shock from the Detroit bankruptcy.”

Defying History

The $3.7 trillion municipal market has typically gained in July and August as investors receive cash from coupon and principal payments while issuance dwindles.

Yet demand from individual investors, who own about 70 percent of local debt either directly or through mutual funds, collapsed over the past two months as a growing economy fueled bets that interest rates will rise. Individuals pulled $11.8 billion from all muni mutual funds in the past month, the most since at least 1992, Lipper US Fund Flows data show.

Just as withdrawals began to slow, Detroit sought court protection on July 18. The move led Meredith Whitney, founder of Meredith Whitney Advisory Group LLC, to write an article in the Financial Times saying Detroit’s filing “should not be regarded as a one-off” in the municipal market.

The banking analyst incorrectly predicted in December 2010 that there would be “hundreds of billions of dollars” of muni defaults in the following 12 months.

Whitney Wave

July marked the third straight month of declines for munis, the longest slide since the month after Whitney made the forecast on CBS Corp.’s “60 Minutes.”

“The effect of these negative headlines on the muni market should not be ignored,” Dan Toboja, vice president of muni trading at Ziegler Capital Markets in Chicago, said in an e- mail. “Traditional individual buyers of muni funds invest for peace of mind. If munis appear to have even marginally more risk the buyer base shrinks.”

The higher yields may pull some individual investors back into the market.

Benchmark tax-exempt munis maturing in 10 years have a taxable-equivalent yield of 4.82 percent. That compares with an interest rate of about 2.6 percent on similar-maturity Treasurys.

“I don’t believe Detroit means the entire muni sector is in disarray,” said David Kotok, chief investment officer at Sarasota, Florida-based Cumberland Advisors Inc., which oversees about $2.2 billion of munis. When yields on tax-exempt local debt exceed those on federal securities, “the tax-free muni is a terrific buy,” he said in an interview.

Cash Ahead

Muni investors will receive $36 billion in August from coupon, redemption and principal payments, according to Chris Mauro, head of muni strategy at RBC Capital Markets in New York. That dwarfs the $12 billion in debt that states and cities are set to sell over the next 30 days, data compiled by Bloomberg show.

CNA Financial Corp., the insurance unit of Loews Corp., said it added local debt after the decline. CNA held munis that cost $10.1 billion as of June 30. Chief Financial Officer Craig Mense on a July 29 conference call said the market presented “attractive yield opportunities.”

Past performance suggests buyers such as CNA Financial will be rewarded with gains in August. State and city bonds have had positive returns every August since 2008, Bank of America data show.

2003 Precedent

In 2003, when local debt declined 4.6 percent in July, the market rebounded with a 1 percent gain in August and a 3.5 percent return in September.

“The relative value of munis should bear out and outperform Treasurys over the coming six to 12 months,” said Alwine, head of muni funds at Vanguard in Valley Forge, Pennsylvania. The company holds more than $100 billion in local debt. “We’ve been looking to add munis at these levels.”

Investors will have an opportunity to buy debt from the states of Washington and Alabama next week, as local governments are set to offer $6.2 billion of bonds, data compiled by Bloomberg show. That’s more than the $5.3 billion pricing this week.

Longer-dated munis have trailed Treasurys even more than their 10-year counterparts. At 4.54 percent, yields on 30-year benchmark munis are about 125 percent of those on like-maturity federal debt, a one-year high.