Muni Bond Scare Masks Returns Municipal bonds used to be the quintessential safe-but-dull investment. But ominous headlines about cities, recently including San Bernardino and Stockton in California filing for bankruptcy, have spurred some investors to rethink these investments. Municipal bonds historically pay a lower rate of interest than taxable bonds because these returns are free of federal taxes and exempt from state taxes if the purchaser lives in the state of the issuer. The recession of 2007-2009 and its protracted slow-growth aftermath have put severe financial pressure on governments, as higher unemployment has decreased tax revenues. That has led to a spate of municipal bankruptcies and, as a result, a general perception of peril for the muni bond market. In 2010, analyst Meredith Whitney spooked the muni bond market when she forecast "hundreds of billions of dollars" in municipal defaults. Yet this hasn't been the reality. As of the end of 2011, muni bond defaults in the $1.3 trillion S&P Municipal Bond Index totaled .58 percent, with just over $1 billion in new defaults last year. Sure, that was painful for these investors, but even in this time of broke governments, it's the exception, not the rule. More than 99 percent of bonds issued by governments are still paying interest and principal to investors. That's a mere scintilla of the damage that Whitney predicted. Moreover, even when local and state governments go belly-up for a time that doesn't mean they end up defaulting on their bonds. Under Chapter 9 federal bankruptcy, the local government or tax authority must present a restructuring plan to the court which could include delayed payments, reduced principal and extended maturities. For example, Cleveland defaulted on its debt in 1978 but, by 1984, it had paid off the debt under court supervision. Cleveland's outcome, far more likely historically than default, shows that the greater risk is that investors may have their interest payments restructured â hardly the default scenario of lining up with other creditors to take pennies on the dollar. While Treasury bonds are paying around 1 percent and bank CDs not much more than that, muni bond investors can reap relatively substantial tax-free gains. For example, State of California bonds due in 2036 were yielding 3.05 percent and bonds issued by Puerto Rico paid 4.35 percent, tax-free to residents. Those who can tolerate high risk can find bonds issued by authorities and small taxing districts paying 10 percent to 15 percent. Compare that with Treasury bond yields â the one-year bond was yielding 0.15 percentâat the end of a year your $10,000 would have earned just $15 in interest, and you'd owe income taxes on that. Even the yields of 10-year Treasuries, which offer higher returns than their shorter-term cousins, paled in comparison with munis, returning only 1.72 percent. Because of the over-reaction to doomsday predictions and the scary headlines about struggling cities, the yields on many muni bonds are substantial relative to their risks, given their performance thus far in this new era of governments in dire fiscal straits. Index returns for municipal bonds were 5.82 percent per year for the five-year period ending in July of 2012. The yield on the index was 3.27 percent as of the end of July. Over the same five-year period, the S&P 500 stock index returned 1.1 percent per year. Should you buy, sell, or hold muni bonds? If you are in a higher tax bracket, muni bonds are an attractive investment because of their tax-free income and relative safety. Even if your means are more modest, munis can be an effective way to diversify your portfolio, especially if it's heavy on stocks. As with other investments but even more so, diversification is the key. You certainly shouldn't put all fixed-income eggs in a muni bond basket. Rather, it's a place for a portion of your total fixed-income holdings, which might also include corporate and U.S. bonds. It's important to consider whether you have the time and skills to research and judge which bonds to buy. Most individual investors would not pass this test, so hiring a manager makes good sense. You can get this expertise by investing in mutual funds (closed-end or open), exchange-traded funds (ETFs) or separately managed accounts â all run by professional investment managers. As a practical matter, few individual investors can afford to invest directly in munis because high minimums for purchasing a single bond preclude diversification for most people. Here are some points to keep in mind about investing in munis: â¢ Diversify geographically. Vary your investment among different states and cities â of course, those with higher credit ratings because of lower risk. Like other bonds, munis are rated by Standard & Poor's and Moody's from top-rated AAA to CCC, for junk. â¢ Focus on revenue. Concentrate on bonds for projects that deliver a direct return to the government or authority issuing the bond, such as a toll road or a bridge. This decreases your risk, compared with the vague accountability that sometimes bedevils purchasers of general obligation bonds, in which governments pledge to pay bond holders rather than linking these payments clearly to revenues received from specific projects. â¢ Look for insured bonds. This usually means they're more expensive, but it gives comfort to the buyer. This is no panacea, however. If pervasive conditions affecting many governments trigger widespread defaults, in some states this insurance may not be worth the paper it's printed on. â¢ Don't be penny-wise and pound-foolish about risk versus rates. Often, you'll find that a hair more interest is accompanied by significantly more risk. â¢ Never hold muni bonds in a tax-deferred vehicle such as an IRA or a 401 (k) plan. You want to save the limited tax-deferred capacity in IRAs or 401 (k) s for investments that are taxable. Regardless of which muni issues you decide on, remember that if returns sound too good to be true, they probably are. If you see sky-high rates, have another look at risk factors. Ted Schwartz, a Certified Financial PlannerÂ®, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the advisor to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.