How to Play It Safe With Muni Bonds

Defaults are rare, but it pays to be cautious.

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Defaults in the municipal bond market can happen, as some investors recently discovered. Municipal bonds, which are generally some of the safest investments, are issued by states, municipalities, or counties, and are usually exempt from federal, state, and local taxes. Muni defaults—such as those on bonds issued this year in Jefferson County, Ala., and Harrisburg, Pa.—are not common, but in an era of budget cuts and lower revenues, it's important for investors to be aware of the risks. Here are a few general rules for muni investors to follow:

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Buy general obligation or essential services bonds. Some experts say average investors should primarily invest in general obligation debt—bonds backed by the full faith and credit and unlimited taxing power of that municipality—and essential services revenue bonds, which are backed by a revenue source that is deemed essential, such as those issued by the local water and sewer authority. "First and foremost, buy general obligation bonds backed by a real municipality, and buy essential purpose revenue bonds backed by real facilities that exist and have a history of paying," says Bill Walsh, president and chief executive officer of investment firm Hennion & Walsh. The majority of muni bond defaults, says Rob Williams, director of income planning at the Schwab Center for Financial Research, are those issued in the housing and healthcare sectors. That's because they're a bit more speculative and not considered essential services, Williams says.

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Stick to high-quality bonds. Currently, municipal bonds are offering a higher yield than many types of fixed-income investments like treasuries, Walsh says, and they can provide a steady yield for income seeking investors. It's important to pay attention to the credit quality of different bond issuances. Walsh recommends that investors stick to investment-grade municipal bonds, the highest rated muni bonds available. "Stories like Harrisburg are getting a lot of attention and press—and it's not insignificant—but it's certainly an outlier compared to what's a vast and diverse market for muni bonds," Williams says. "Defaults for muni bonds in general, especially those that have investment-grade ratings, is very infrequent."

[See 4 Reasons To Look Beyond Treasuries.]

Diversify. As with most investments, one of the easiest ways to protect your money is to spread it among a wide range of muni bonds with different maturities and issued in various parts of the country. That way you'll have a mix of general obligation and revenue bond holdings that expire on different dates, and you won't be making a bet on any single issuer, type of bond, or region of the country. Walsh recommends that investors especially consider areas of the market that they understand—like bonds issued in their home state or near the area they live and work. Keep in mind, though, that the smaller the municipality, the less liquid the investment may be. Williams suggests that investors diversify by also looking at out-of-state bonds. "You might also find higher yields in some other states that don't have as much debt out in the market and not as much demand," he says. It's also important to focus on large issuers like states because their offerings are usually more liquid and sometimes safer from default. Interested investors can use brokers like Charles Schwab or Walsh's firm to select individual municipal bonds. If you want to leave the selection to experts, there are a wide range of diversified mutual funds.

[Check out U.S. News's category page to find the right municipal bond investments for you.]