By limiting your munis to maturities of three to six years, you'll reduce the risk of inflation eating away at the value of your bonds. By James K. Glassman, Contributing Columnist March 14, 2011 At a time of the worst budget shortfalls in decades, are you ready to lend your hard-earned money to the state of California? The city of Houston? How about Detroit?When you buy a municipal bond, you extend a loan to a state, county or city, to one of its agencies or, in some cases, to a corporation with special borrowing privileges. With the U.S. unemployment rate at 9% and home values down sharply, these borrowers are having a tough time raising revenues. Prices of muni bonds have fallen, which means that interest rates on those munis have risen -- to the point, in some cases, that yields are higher than they are for Treasury bonds of the same maturity. So do munis now represent fabulous opportunities or obvious traps to shun? The Numbers The most attractive feature of munis, in good times and bad, is the exemption of their interest payments from federal income taxes. If you buy munis from your own state or city, the interest may be exempt from state and local taxes, too. In early February, the average yield on the 20 long-term munis that make up the Bond Buyer index was 5.3%. In the 35% federal tax bracket, you would need to earn 8.1% interest from a taxable bond to put an equivalent amount in your pocket. At the time, 30-year Treasury bonds were yielding 4.5%. Advertisement The comparative advantages of shorter-term munis are even more impressive. A Rio Rancho, N.M., School District bond maturing in August 2015 and rated double-A1 by Moody's (almost the highest quality) recently yielded 2.3%, equivalent to a taxable yield of 3.5%. A Treasury note with the same maturity yielded 2.1% -- significantly less. There's a reason interest rates on munis are so tempting: As concerns about the finances of states have risen, so have muni yields. The yield on the Bond Buyer 20 index was just 3.8% in mid October. Worries about the health of municipal finances spiked when Meredith Whitney, a well-known analyst, predicted a collapse of the muni market when she appeared on a December 19 segment of CBS's 60 Minutes. Said Whitney: "You could see 50 sizable defaults. Fifty to 100 sizable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults." A month later, the New York Times published a front-page story that said, "Policymakers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts." Small investors began pulling money out of muni-bond mutual funds at an unprecedented clip, and prices in the fourth quarter suffered their worst decline in 16 years. Advertisement Whitney, who also predicted a "panic in the muni markets," quickly found herself the target of criticism from bond analysts accusing her of ginning up a panic herself. Typical was Dick Larkin, a director of credit analysis for Herbert J. Sims & Co., an Iselin, N.J., investment firm. On Fox Business News, he called Whitney's assertions "ludicrous" and told his clients that "I would bet my career" that she is wrong. A Bloomberg news story cast further doubt on Whitney's credibility. The truth is that muni issuers rarely default, in part because public entities, unlike businesses, have the power to tax. A study by George Hempel, of Washington University in St. Louis, found that muni default rates were just 1.8% annually even during the Great Depression, and that state and local agencies eventually repaid 97% of what they owed. Research by Moody's found that an average of only one bond issue out of 10,000 defaulted annually from 1970 to 2006. From 1999 to 2009, only ten muni issuers failed to make debt payments, according to Fitch, the third-largest ratings firm. And last year, there were just six municipal bankruptcies, five of them tiny. This time, however, could be different. According to the Center on Budget and Policy Priorities, "2012 is shaping up as states' most difficult budget year on record. Thus far, some 44 states and the District of Columbia are projecting budget shortfalls totaling $125 billion for fiscal year 2012." Harrisburg, the capital of Pennsylvania, nearly missed a $3.3 million payment on a general-obligation bond in September. Of the two basic kinds of muni debt -- general-obligation issues and revenue bonds -- GOs are supposed to be safer because they're backed by taxing power. A revenue bond is funded by a stream of income from, say, a turnpike or a college dormitory. Advertisement Even bullish bond managers, such as Josh Gonze, of Thornburg Intermediate Municipal Fund (symbol THIMX), are taking care. "We may see a small elevation in defaults," he wrote to shareholders recently, "but we don't expect a tidal wave." Gonze is avoiding bonds in places such as Detroit and Puerto Rico, as well as "revenue bonds for projects with weak financial results." Another risk to munis, which is shared by other bonds, is rising interest rates. Say you buy a bond that yields 4% today and matures in ten years. Now, assume that the rate on a similar bond jumps to 5%. To attract a buyer in the marketplace, you'll have to reduce the price of your 4% bond. In fact, prices of many kinds of bonds have suffered in recent months as inflation fears have mounted and rates have risen. Stay Short So does it make sense to buy munis? Only if they're highly rated and are set to mature fairly soon. Stocks should make up the part of your portfolio that seeks high returns in exchange for higher risks; bonds should give you stability. By limiting your munis to maturities of three to six years, you will have to accept lower yields, but you will also reduce the risk of inflation eating away at the value of your bonds. If you insist on longer maturities, then emulate Gonze and the other Thornburg managers by laddering, or constructing a portfolio of bonds that mature in successive years. That way, if rates rise, when one bond comes due you can use the proceeds to buy a new bond with a higher yield. Advertisement Besides credit and interest-rate risk, munis present another problem. There are more than one million separate issues outstanding, and sorting through them is practically impossible for the average investor. Getting information on Harrisburg's finances is a lot tougher than finding data on General Electric or Target. In addition, the market for many munis is thin, with traders capturing a large spread between the price at which you buy a muni bond and the price at which you sell it. To do well buying individual munis, it helps to have an adviser who specializes in these kinds of bonds. The problem with investing in a mutual fund that owns municipal bonds is that the fund, unlike a portfolio of individual IOUs, never matures. If, say, interest rates move up between the time you buy a fund and the time you sell it, you will almost surely lose money. Still, if you prefer a packaged approach, you should put your trust in an exchange-traded fund managed by a firm with a great track record, with low expenses and a clear strategy. For instance, Pimco Intermediate Muni Bond Strategy (MUNI) owns 108 issues with maturities averaging six years; in early February, it yielded 2.8% (equivalent to a taxable 4.3% if you're in the 35% bracket), and it carries an expense ratio of 0.35%. If you want to keep maturities even shorter, consider iShares S&P Short Term National AMT-Free Muni (SUB). As its name indicates, this ETF does not hold bonds that produce interest subject to the alternative minimum tax. Holdings mature in an average of about two years, and the recent yield was 1.1% (equivalent to a taxable 1.7%). With such a low yield, though, the fund's expense ratio of 0.25% rankles a bit. In the end, Meredith Whitney could turn out to be right -- but only if the U.S. economy takes another sharp downward turn. I would estimate the chances of such a horrifying development at about 10% to 20% -- pretty remote, but still enough of a possibility to take a lot of care with the part of your portfolio that's supposed to keep you safe. James K. Glassman is executive director of the George W. Bush Institute in Dallas. His book Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence was recently published by Crown Business. He owns none of the securities named. Recommended funds are in boldface.