Invest Wisdom

Municipal bonds are often written about as if they’re as safe as Treasury bonds. As long as U.S. debt is denominated in dollars, the Treasury Department isn’t going to default on its debt (I mean, I suppose it could, but why?). On the other hand, the states and cities that issue municipal bonds can’t print money but they can tax the hell out of their constituents to pay debt off.

That’s led municipalities to have extremely low default rates. In fact, before the crisis hit its peak, single-A rated munis had a historical default rate of 0.0084%, which is 80 times lower than the historical default rate of AAA-rated corporate bonds.

California is one state facing serious budget difficulties.

Of course, that was before tax revenues fell through the floor. Now, states and cities want access to the same bailout money used to help banks. Congressmen have already written legislation to specifically help those cities that lost a lot of money making investments in Lehman Bros. debt. (Seriously? Cities were investing in Lehman Brothers?)

Of course, as an investor just looking to grow his money safely, you’re just wondering whether investing in your local muni bond is worth the risk of default. Here’s what I would consider.

What do you get for the risk?

The absolute safest investment you can make is one in a U.S. Treasury bond. So when considering a muni, the first and easiest thing to check is how much extra the muni will pay you for taking on additional risk.

Municipal bond rates will vary by municipality, but according to Bloomberg, the average, 5-year Treasury bond has a yield of 2.19%. The average 5-year muni bond’s yield is 1.82%. But because muni interest isn’t taxed by the Feds (and if you buy one from your own state, in most cases you avoid state taxes), the effective yield is 2.53%, assuming it would have been taxed at 28% otherwise.

Step one complete…for taking on the risk that a city or state defaults, you earn an extra 0.34% of yield for the average 5-year muni bond.

What is keeping a city or state from defaulting?

The main reason investors have long assumed states and cities won’t default is the one we’ve already addressed: The ability to tax. If a city had a $100 million bond payment coming up and didn’t have the money, it could simply raise $100 million in taxes by adding a temporary…I don’t know…marshmallow tax on anyone who wanted to make s’mores for the next 12 months.

Cities and states also don’t want to default because it seriously crimps their ability to raise capital later on. What investor wants to lend money to a city that recently defaulted? If a city did default, investors would demand much higher interest rates later on to make up for the risk, something that could hurt a city for decades.

Those reasons for not defaulting were pretty strong when cities and states faced their individual budget difficulties. But since the recession is making dozens of cities stare default in the face, the stigma of defaulting could disappear quick. (”Hey, everybody’s doing it!”) The question becomes: Are politicians more loathe to raise taxes in a recession or to shaft investors, many of whom their constituents are already angry at?

Warren Buffett recently said as much, though he was referring to muni bonds protected by insurance companies.

But finally, there’s this federal backstop that may or may not exist. Every state’s senators and representatives don’t want to see their hometowns go into bankruptcy. So they could offer up the seemingly unlimited coffers of the Federal Government to save them, and by extension, the poor saps who bought their muni bonds.

All of these reasons that things could be more or less dangerous are pretty hard to measure. And right now, the market seems to think that on the whole, the muni market is not nearly as dangerous as it was six months ago. Still, I don’t know if I’d run out and buy California general obligation bonds.

So what to do?

Although it’s not clear who, if anyone, is not going to make it out of this mess with their solvency, you don’t have to make a bet on any one government. There are plenty of mutual funds out there that will diversify you across muni bonds.

Take a look at this list of Fidelity muni bond funds for many states. I picked Fidelity at random. Any number of fund companies offer these.

If your state doesn’t give you a state tax break, you can also look at national muni bond funds (Since I’m already at their site, here’s Fidelity again.)

These options give you diversification across governments, which should cut down on some of your worries. No, it’s not a guarantee. Treasury bonds are still safer. But if you don’t have a ton of money to diversify with individual bonds, it’s better than staking a huge sum of money on one city’s fortunes.

— Joe Light