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Municipal bonds: an investment with civic pride

Muni issues grow in turbulent times, offering higher yields.

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Opportunities notwithstanding, munis also come with risks, such as the possibility that they'll lose value in the bond market. From Jan. 1 through mid-October, munis' trading values have slid about 9 percent, according to benchmark indices. Worries about the solvency of certain municipal bond insurers have scared some investors away from this traditionally sleepy investment class. Add in this fall's liquidity crisis in credit markets, and the situation can still spell trouble for bond owners who must sell within a couple of years.

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But observers say a few cautious rules of thumb, even in these turbulent economic times, can enable investors to use munis to help them sleep well at night.

One approach to limiting muni risk involves seeking out diversity. By buying into a municipal-bond mutual fund or an exchange traded fund (ETF) that tracks particular bonds or a bond index, investors spread their risk across many debtors in case one or more default. Sutherland is considering loading up on closed-end municipal bond funds if and when they start trading later this year at 15- to 20-percent discounts off their net asset values (NAV).

Discounts Mr. Sutherland has seen lately, as high as 28 percent off NAV in early October, suggest to him that "people are being completely driven by fear and not by any component of rationality."

Investors seeking meaningful social returns may want to buy bonds associated with particular communities or projects. Such debt instruments, picked up on favorable terms, can also give a portfolio more kick than a diversified bond fund. For minimizing risk in this domain, experts generally agree on two tips: 1) seek out highly rated bonds, such as A+, AA, or AAA, and 2) opt for "general obligation" rather than "revenue" bonds.

Certain revenue bonds can be risky because repayment depends on revenues generated from a particular project. On Ms. Reuben's caution list: Revenue bonds issued to build or expand regional airports in fast-growing areas. While such projects might evoke civic pride, they also might stumble if hard times lead to fewer fliers. Bond-holders could then get stuck holding unsellable paper.

General-obligation bonds, on the other hand, are backed by a government's tax coffers. That makes defaults highly unlikely, Reuben says, since even a financially troubled government can use its taxing authority to settle its debts.

"If you're getting 4, 5, or 6 percent [in tax-exempt yields], that's a pretty good return on something that's a really safe asset," Reuben says. "No state has really defaulted on general obligation debt, and it's very rare for there actually to be bankruptcies or defaults on local debt."

Still, investors may not wish to worry about delayed payments or other complicating factors. Such risk-averse types might consider avoiding bonds from communities hardest hit by the housing market downturn, Mr. Avery says. That's because falling home values may eventually translate into drops in property-tax revenues and financial strain for local governments. Better bets, he says for example, might be bonds from Midwest farming communities which have prospered with the recent run-up in agricultural commodity prices.

Others question whether insurance on a bond actually reduces risk. Kansas City money manager Stuart Speer says the financial crisis has led him to believe that "if a bond is insured, it would be riskier than if it were not insured." That's because if a credit-rating agency discovers subprime or other bad debt on an insurer's books, then it's apt to cut the insurer's rating, and all bonds insured by that company would consequently lose value on the open market.

Among the best moves muni investors could make to limit risk, money managers say, is to give themselves a long horizon. Planning to hold a bond to maturity, Avery says, allows a bond holder to relax even when a bond's trading value sinks in the short term. Such slides in value can happen with rising interest rates or other market-moving factors. When they do, muni investors need to be psychologically prepared.

"One of the side effects of having good long-term performance is that there is going be short-term volatility," Sutherland says. "That's a fact. It's reality. And you can't get around that."