Five Reasons Why Investors Shouldn't Fear Muni Bonds

by Francesca Lee

The municipal bond sector spooked investors in the first quarter of 2011. When muni issues totaled the lowest amount in ten years -- $44.4 billion compared to $132.8 billion in the last quarter of 2010, according to Thomas Reuters -- squeamish investors dumped their holdings and scrambled for the exit. But where some forecasters see Armageddon, others see an opportunity to exploit (cyclical) fears and buy carefully selected bargains of credit-worthy, tax-free income producers.

Defaults Are Rare

Here's the scoop on defaults: They're rare and the riskiest issues are the worst offenders. According to a Moody's 2010 Investor Report on U.S. Municipal Bonds, 54 defaults occurred out of 18,000 issues between 1970 and 2009. A scant $8.9 billion in bonds (of the $2.8 trillion market) enter default. Of those, 85 percent are the bottom-of-the-barrel issues. Defaulting is a measure of last resort. Consider this: If a municipality stiffs investors, it's difficult to issue a debt instrument in the future without also offering substantially increased yields to attract investors.

Top Rated Funds Hedge Risk

Wealthier areas pay higher taxes. Although the yields may be slim in comparison to high-risk issues, and anything can happen, you're less likely to lose sleep over these purchases. Buying muni bonds from cities with high foreclosure rates courts trouble because tax revenue is linked to property. High foreclosures equal low tax revenue. But with a little research you can locate credit-worthy cities with bond issues that fit your investment style and lowers the fear factor.

Revenue Generating Projects Pay

Bonds tied to revenue generating projects -- city development, sewer and water supply, utilities and essential service bonds -- are more likely to generate revenue streams, according to an August, 2010 BlackRock report. These bond issues have a critical hallmark that attracts every investor: value. Take a look at national bond funds and bonds issued for projects with long-range community service potential. These have plenty of upside.

Diversification Protects Portfolio

Rather than concentrating your capital on one batch of state issued bonds, think of diversifying with bond funds from different regions and industries. The muni bond portion of your portfolio should adhere to the diversification principals of your overall investment strategy. If you'd rather delegate the homework, read up on diversified muni funds with exposure in four or five sectors.

Underperformers at Discount Rates

Fear drives reactionary investing. If you can detach yourself and take an objective assessment, bargains emerge from the rubble. But a bargain is not the same as high-risk money pit. For instance, downgrades in U.S. credit rating affect states dependent on Uncle Sam for a significant portion of their funding. These bonds have more risk implied and the issuing states are on Moody's watchlist for potential credit downgrades. However, bonds from credit-worthy states are still your best bet, and because of market jitters, you can purchase them at fear-discounted rates. With the mass exodus, underperformers are low-hanging fruit to pick.

About the Author

Francesca Lee has more than 12 years of experience as a business writer, specializing in personal finance and education. Her articles have appeared online at Wave Newspapers, Turning Point Magazine and Facsnet. Lee studied political science at the University of California, Berkeley.

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