Despite some recent defaults, tax-free bonds are still generally reliable investments. By Kathy Kristof, Contributing Editor October 1, 2012 In today’s low-yield world, municipal bonds offer some comfort to income-starved investors, especially when compared with other historically trustworthy investments. As the accompanying chart shows, a triple-A-rated tax-free bond maturing in ten years yields 1.8%. For an investor in the 35% federal tax bracket, that’s equivalent to 2.8% from a taxable bond. By contrast, a ten-year Treasury bond pays a puny 1.5%.SEE ALSO: The 5 Biggest Muni Bond Defaults Most are safe. Investors have long viewed muni bonds as safe havens. Even now, as deteriorating public finances have spurred a number of cities to file for bankruptcy, less than 0.3% of muni bonds have gone into default in the past three years, says Matt Fabian, a managing director at Municipal Market Advisors, a research firm. That said, this is not the time to throw caution to the wind, says Marilyn Cohen, president of Envision Capital Management, a Los Angeles investment firm. Diversify your holdings. The best protection against municipal bankruptcy is to diversify your holdings. You can do that easily by investing in a fund. The downside is that funds charge ongoing fees, and in a low-rate environment even a relatively modest charge can eat up a big chunk of your return. The other shortcoming of funds is that you can easily lose principal if you sell at an unpropitious moment—say, after a prominent analyst issues a dire warning about the sector or after a run-up in interest rates (bond prices move opposite rates). If you hold an individual bond to maturity, you know you’ll get back the face value (assuming the issuer makes good). Advertisement Fund picks. Among open-end funds, our favorite is Fidelity Intermediate Municipal Income (symbol FLTMX). The fund, a member of the Kiplinger 25, charges 0.40% a year for expenses and yields 1.4% (yields and related data are through July 31). Among exchange-traded funds, a solid choice is Market Vectors Intermediate Muni ETF (ITM). It charges 0.24% annually and yields 2.0%. Nuveen Municipal Value (NUV) is a rare closed-end muni bond fund that does not use leverage, or borrowed money, to juice up interest payouts. However, it is more vulnerable to rising interest rates than the others because it invests in longer-term bonds. At a share price of $10.39, Nuveen yielded 4.5% and traded at a modest 3% premium to the value of its underlying assets. It charges 0.65% a year. Understand what you’re buying. If you prefer to buy individual bonds, you must understand what you’re buying, says Cohen. Say a revenue bond is supported by income generated by a particular project. Be sure the undertaking has real and enduring demand—utility or sewer projects, for example, that a community can’t live without—and that the issuing agency can cover payments to investors from its anticipated income stream. (Your broker should be able to help you find the relevant numbers.) If you invest in general obligation bonds, steer clear of issuers with high foreclosure and jobless rates—signs of municipalities under stress. Also be sure to check out the bond’s rating with the three rating agencies—Fitch, Moody’s and Standard & Poor’s—as well as the agencies’ analysis of factors that played into the rating. Kathy Kristof is a contributing editor to Kiplinger’s Personal Finance and author of the book Investing 101. Follow her on Twitter. Or email her at firstname.lastname@example.org. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!