The 7 Pillars of Investing in Tax-Free Bonds

If you're a longtime investor in municipal bonds, the recent spate of dire warnings about the financial health of the nation's state and local governments is bound to leave you queasy. You may even get nervous enough to sell your muni holdings and vow to stay away from the category until things improve. Don't do anything rash, but do follow these seven guideposts in your investing.

1. Most munis are safe. Arkansas was the last state to default on its munis -- and that was in 1933. Yet investors have pulled about $40 billion out of muni-bond funds since mid November because they fear a growing number of defaults. True, I wouldn't be surprised if the number of defaults this year reaches its highest level since the Great Depression. But the prediction by Meredith Whitney, a Wall Street analyst who in 2007 accurately predicted the meltdown in bank stocks, that municipalities will suffer hundreds of billions of dollars in defaults is pure bunk. (If you don't believe me, read Whitney Municipal-Bond Apocalypse Short On Specifics). Indeed, muni yields have become so attractive that some smart investors, such as Pimco's Bill Gross, are loading up on tax-free bonds in their taxable-bond funds.

2. Sell high-yield funds. In my 20 years of writing about investing, I've seen more money lost in high-yield bond funds, taxable and tax-free, than just about anywhere else. The Wall Street Journal recently reported that the Securities and Exchange Commission has launched a fresh probe into whether sponsors of some high-yield tax-exempt funds have overstated the prices of numerous thinly traded munis. Many of these bonds trade by appointment -- that is, rarely -- so even if a fund shop's pricing of them is legit, it's still playing a guessing game. If you own a tax-free fund with "high income" or "high yield" in the name, or that yields more than 5%, sell.

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3. Don't buy individual bonds. Many muni experts recommend a laddered portfolio of individual bonds structured so that a bond matures every year. You might, for instance, own a bond that matures every year for the next ten years. In normal times, that's a perfectly sound strategy for affluent investors. But these aren't normal times. A few defaults in a muni fund might cost you a little money; a default in one bond in a portfolio of five or ten bonds could be catastrophic.

What's more, if you need cash and decide to sell a muni bond, you could take a haircut of 5% or more because of the wide gaps that are typically found between buy and sell prices -- and that's assuming there's no cloud over the bond's issuer. For that reason, don't sell an individual muni bond, even now, unless you're certain you're getting a good price. With a fund, of course, your sell price will be that day's closing net-asset-value per share.

4. Stick with low-expense, high-quality funds. Many funds take more risk than they should to make up for high operating costs. That's why the first number to look for on a muni fund is its annual expense ratio. The lower, the better. Vanguard muni funds typically don't charge more than 0.25%. T. Rowe Price and Fidelity funds charge less than 0.60%. Unless you're using an adviser, why look elsewhere?

The next number to consider is a fund's average credit quality. True, the bond-rating agencies are far from perfect. But I wouldn't buy any fund with an average credit quality below single A. Check a fund's credit quality at Morningstar.com.

5. Beware of single-state funds. Think twice before buying a single-state muni fund. Yes, these funds pay you income that's free from federal and state taxes. But single-state funds almost always charge higher fees. My advice: If you live in a state with a lot of fiscal problems, buy a national fund. If you're in a high-tax state, though (say one with income-tax rates over 6%), and your state looks to be in relatively good shape, consider a single-state fund from Fidelity, T. Rowe Price or Vanguard. If they don't offer a fund for your state, be careful about buying a fund from another shop.

6. Watch the duration. Duration measures how sensitive a fund's price is to rising (or falling) interest rates. If a fund has an average duration of 5 years, it means that its price should fall about 5% if interest rates on similar bonds rise one percentage point. Morningstar.com lists the average duration for most bond funds.

Unless the crisis in Japan upends the economic recovery in the U.S., which I think is unlikely (see PRACTICAL ECONOMICS: Japan's Disasters Pose Only a Slight Risk to the U.S.), interest rates here should rise over the long term. As such, avoid funds with average durations much longer than 7 years. Shorter durations are better.

My favorites are Fidelity Intermediate Municipal Income (symbol FLTMX), a member of the Kiplinger 25, and Vanguard Intermediate-Term Tax-Exempt (VWITX). The Fidelity fund charges 0.39% annually, has an average credit quality of single A and an average duration of 5.4 years. The Vanguard fund charges 0.20%, has an average credit quality of double A, and its duration is 5.8 years.

7. Falling prices mean higher yields. Just because your fund loses a bit in price doesn't mean you should sell. Virtually every muni fund took a tumble late last year and early this year because of rising fears of default. When a high-quality muni fund falls in price, its yield rises. Be careful, of course, if you're investing with a short time horizon. But for long-term investors, higher yields eventually boost your returns.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.

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