Despite a few scare stories, municipal bonds remain among the safest investments. By Andrew Tanzer, Senior Associate Editor September 2, 2010 Something is amiss when the once-sleepy municipal-bond market becomes fodder for screaming newspaper headlines. An ill-fated sewer project sinks a county in Alabama. A disastrous incinerator in Harrisburg burns a hole in Pennsylvania's finances. A Las Vegas nonprofit organization rolls the dice and loses on a monorail system financed with high-yield muni bonds.The news on state, city and local government finances is no cheerier. Deficit champ California still has no budget. Illinois and New Jersey have awakened to the fact that it's becoming mathematically impossible for them to make good on generous pension promises to public-sector workers. Governors continue to make pilgrimages to Washington, tin cups in hand, requesting more federal subsidies. So has the muni-bond market become a much riskier place to invest? The answer is yes and no. Consider this bit of context. Historically, default rates in the muni-bond market have been remarkably low. For example, from 1970 through 2009, Moody's calculates, just 0.06% of investment-grade muni bonds defaulted within ten years after their issuance, compared with 2.5% of similarly rated U.S. corporate bonds. Advertisement Beware undue pessimism Times have changed, and many states and localities are facing their worst budget problems since the Great Depression. But John Miller, who runs Nuveen's large municipal-bond department, cautions against jumping to hasty conclusions. "There is a distinct difference," he says, "between what the fiscal balance of a municipal government looks like versus the municipality's ability to service and repay its debts on time." Debt service accounts for a low percentage of nearly all budgets, says Miller, and many state constitutions require that repaying debt be the number-one or number-two spending priority. States can't print money, but they do have the power to raise taxes and fees and fire workers to help service their debts. In this case, we're talking about general-obligation bonds, which are secured by the issuer's full faith, credit and taxing power. Revenue bonds, which are secured by money collected from tolls, user fees or rents, make up a large part of the muni-bond industry. In this context, too, the headlines are overblown. A default on a project in Harrisburg or Las Vegas has no bearing on the health of a muni-bond-financed turnpike in New Jersey or a hospital in Virginia. George Strickland, co-manager of Thornburg Intermediate Municipal Fund, says he suspects that the muni default rate will tick up to between 0.1% and 1% -- still a low rate. That said, investors need to be aware of a couple of major shifts in the muni marketplace. Before the financial crisis of 2007-08, muni-bond insurance firms guaranteed well over half of all tax-free issues. That umbrella helped many bonds, regardless of underlying credit quality, obtain triple-A ratings (meaning that there was almost no chance that they would default). This homogenized the market, and investors tended to buy bonds almost without looking. Then the insurance companies blew up, and the whole system unraveled. Since then, fewer than 10% of new municipal offerings have been insured, and triple-A-rated bonds have become scarce. Plus, the value of the bonds, which now have to stand on their own, have become more sensitive to market sentiment. Investors must be far more discriminating when they buy bonds. Advertisement The other big change is the success in the marketplace over the past 18 months of Build America Bonds (see Munis' Worthy Rivals). BABs are taxable munis with federally subsidized interest rates. They have attracted new muni investors, such as pension funds and overseas buyers, and siphoned off supply from tax-free munis. As a result, there is a scarcity of new, long-term tax-free bond issues, which has helped to drive up muni prices and force down yields (bond prices and yields move in opposite directions). But munis of all stripes and maturities will become more valuable if income-tax rates rise, as is widely expected to happen on both the national and state levels. Consider this scenario: If you're in the top federal tax bracket of 35% and you invest in a muni paying 3%, that's the equivalent of earning 4.6% from a taxable source, such as a corporate bond. If the top federal bracket climbs to 39.6% (which it will if the Bush tax cuts are allowed to expire), a 3% tax-free return will be tantamount to a taxable yield of 5.0%. Investors have many ways to own munis. We describe four of them here: Do-it-yourself If you prefer to invest in individual bonds, be prepared to do some diligent homework, just as you would before buying a stock. "Instead of sitting back with a portfolio of insured muni bonds, you're now in a new world where credit analysis is much more important than it used to be," says John Mousseau, of Cumberland Advisors in Vineland, N.J. (For advice on how to conduct research and deal with your broker, see How to Research and Buy Bonds.) Advertisement Mousseau, who runs muni-bond portfolios for Cumberland, says that geographic diversification is more important now. He also advises greater diversification by bond sector. Mousseau is generally wary of bonds that are financed by property taxes (which account for more than 70% of local-government revenues). Remember that default is not the only risk in bonds. If bonds are downgraded, prices fall. Says Strickland: "I'm limiting my exposure to bonds issued in New Jersey and Illinois, not because there's real default risk but because I think the bonds will underperform." Of course, if you hold bonds to maturity, you don't need to worry about interim drops in price, as long as the issuer doesn't default. Richard Ciccarone, of McDonnell Investment Management, is wary of risk associated with muni-bond-financed assisted-living facilities that depend on the ability of seniors to sell their houses. Thornburg's Strickland gives ailing Puerto Rico a wide berth: "I don't see a way out for Puerto Rico, which may run out of money in the next few years." But don't be scared off by isolated minefields. The vast preponderance of revenue and general-obligation bonds will pay off on time. Advertisement Take the fund route Mutual funds offer some advantages over buying individual bonds, but they also have some drawbacks. Funds offer diversification and professional management, which is particularly important in the post-insurance era. As institutional investors, they get better prices than you can when they buy and sell bonds. You can redeem a fund at its net asset value (NAV), which solves the problem of finding a buyer at an attractive price if you wish to sell an individual bond. This service comes at a price. High fees take a bite out of your return anytime, but they're especially painful in a low-interest-rate world. And because NAVs generally fall when interest rates rise, fund investors are more susceptible to interest-rate risk than those who buy individual bonds and hold them until maturity. When rates rise, the NAV falls, and if the decline exceeds your (after-fee) interest income, you will lose money. Chris Alwine, head of Vanguard's considerable muni-bond-fund effort, shares the view of many experts that the economy is so weak that rates are unlikely to move much higher over the next six to 12 months. You'll be hard-pressed to find muni-bond funds that cost less than those from Vanguard. It charges 0.20% a year for consistent performers such as Vanguard Intermediate-Term Tax-Exempt Fund (symbol VWITX), which currently yields 3.7%, equivalent to 5.7% for a taxpayer in the 35% bracket. Alwine says he likes essential-services revenue bonds, which aren't facing the budget challenges that states are. "People pay their water and sewer bills, and operators have the ability to raise fees," he says. Fidelity charges a bit more but has a strong lineup of muni-bond funds that are backed by solid research. Mark Sommer, who runs Fidelity Intermediate Municipal Income (FLTMX), also likes essential-services bonds and some hospital-related credits. The fund, a member of the Kiplinger 25, yields 2.4% and charges 0.41% annually. (For more about this fund, see FUND WATCH: This Kip 25 Fund Navigates New Turf for Tax-Free Bonds.) Use ETFs Municipal exchange-traded funds are a relatively recent phenomenon. But the field is growing -- Vanguard has filed to launch three municipal ETFs -- and becoming more diverse. Moreover, muni ETFs have a number of merits: They're well diversified, they're cheap (fees typically run from 0.25% to 0.35% annually), and they're easy to trade. Most ETFs attempt to mimic a muni index. The oldest and largest fund in the sector is iShares S&P National AMT-Free Muni Bond (MUB), which charges 0.25% annually, yields 3.0% and pays monthly dividends. IShares has also launched an intriguing series of target-date muni ETFs stretching from 2012 through 2017. Say you know that you'll have to come up with the cash to pay for tuition in 2015. You can purchase iShares 2015 S&P AMT-Free Municipal Series (MUAD), which invests in bonds maturing in 2015 and will pay back principal and wind up on or about August 31 of that year. If you are willing to accept more risk, consider Market Vectors High Yield Municipal Index (HYD), run by Van Eck Securities. High Yield, which invests in lower-rated munis, yields a handsome 5.8% (equivalent to a taxable 8.9%). It charges 0.35% a year. If you're in a low bracket or investing inside a tax-deferred vehicle, such as an IRA, take a look at PowerShares Build America Bond Portfolio (BAB). It yields 5.8% and charges 0.35% annually. Dabble in closed-ends Finally, let's not forget the proliferation of closed-end muni-bond funds, which, like ETFs, also trade like stocks. The reason closed-ends flourish can be summed up in one word: leverage. About 95% of muni closed-end funds add borrowed money, which pumps up tax-free income. For instance, BlackRock MuniHoldings Fund II (MUH), a long-term fund, yields 6.5%, equal to a whopping 10.0% taxable yield for a high-bracket investor. The downside of leverage is that it dramatically increases volatility. In fact, Alex Reiss, an analyst at Stifel Financial, a St. Louis-based brokerage firm, says the shares of leveraged muni funds can swing wildly according to investor sentiment. For instance, despite the relatively stable value of their underlying bond portfolios, closed-end muni funds plummeted along with stocks during the 2008 bloodbath. But there is no denying that borrowing at short-term interest rates and investing the proceeds in long-term bonds is a strategy that almost always boosts income. That's because, more than in other bond markets, long-term munis almost always yield considerably more than short-term debt. In early August, share prices for the vast majority of closed-end muni funds were higher than the NAVs of the fund's holdings. That is not a good time to buy. But at an early-August price of $14.87, BlackRock MuniHoldings traded at NAV. Invesco Quality Municipal Securities (IQM), another leveraged muni fund that invests in long-term bonds, sold for $14.13, or a 3.3% discount to NAV, and yielded 5.9% (equivalent to 9.1% taxable).