Another big change that affects investors' security selection is the disappearance of bond insurance, which guaranteed that a third party would pay the interest and principal if the borrower defaulted. In 2007, nearly half of all new municipal issues were backed by one of seven insurers, according to UBS Wealth Management research. These insurers were Triple A-rated, enabling any bond they guaranteed to effectively bear the same rating, no matter what the issuer's underlying credit quality.
But because of bond insurers' exposure to subprime mortgages, all but two companies lost their top credit ratings in 2008. Currently, only one is underwriting new offerings-after the two survivors merged. As a result, last year only 9% of municipal new issues carried any such third party guarantees, according to UBS, and only 7% carry them so far in 2010.
"Without the credit insurance, people need to work a little harder to understand what they own," says Kristin Stephens, a municipal bond analyst with UBS Wealth Management. "We are in a new world now, and the market is less homogenized."
With higher defaults, negative headlines and the absence of insurance, you might expect prices for municipal bonds to be depressed. But munis were up 4.6% through July, according to the Barclays Capital Municipal Bond Index, and rose 12.9% last year, its best performance in more than a decade. This price increase has led yields to collapse to just 2.75% for ten-year munis. (Yields move in the opposite direction of prices.)
"Yields on munis are down for the same reason as Treasurys: There has been a flight to safety," says John Hallacy, head of municipal research at Bank of America Merrill Lynch. Munis are still perceived as relatively safe, compared to stocks or even corporate bonds.
Another factor propping up the market is a stimulus program sponsored by the federal government called Build America Bonds (BABs).
Under the program, which began in April 2009, municipalities can issue debt with 35% of the interest costs reimbursed by the federal government. The income from these bonds is not tax free, as it would be with traditional munis, but institutions such as pension funds have found them attractive (unlike traditional munis, which come without taxes and thus lure individual investors).
BABs accounted for over a quarter of muni issuance in the first half of 2010, according to Bank of America. But as a result of the program, tax-free bonds are in short supply, another reason prices are high and yields low. Once the BAB program ends, yields could rise, Hallacy says. But cities and states are lobbying to have the program extended beyond its expiration at the end of this year.
Demand for munis is also sustained by expectations that tax rates are on the rise. Individuals earning more than $200,000 and families earning more than $250,000 will likely be subject to federal tax rates of 36% and 39.6% in 2011, up from 33% and 35% currently.
The higher rates make the tax exemption offered by munis even more valuable. A municipal bond yielding 4% would be worth 6.62% in a 39.6% tax bracket, versus 6.15% previously, according to UBS research. The benefits are even higher if you buy munis issued in your home state, which are double tax-free. States like New York and California may also raise taxes, adding to the potential savings. That tax advantage is available through direct purchases of municipal bonds, or through state-specific mutual funds.
Assuming an investor is willing to take the plunge, analysts offered some rules of thumb for conservative investors. Generally, higher rated bonds-Triple A is the highest-are safest. Another rule of thumb is to buy "general obligation" bonds, or debt backed by the taxing authority of the municipal government, or essential service bonds, which are issued by providers of services like water or sewers.
Be wary of revenue bonds, which are issued to fund projects like airports or toll roads. Repayment of these bonds depends on specific revenue streams that vary with demand for their services. Revenue bonds issued on behalf of private institutions such as hospitals are even riskier. If the institution is unable to meet its debt obligations, the government or agency issuing the bonds is not under any legal obligation to repay the debt.
You may also want to stick to states or large cities. "Unlike cities, states cannot go bankrupt," says Lehmann-although municipal bankruptcies are still relatively rare.
Finally, you can find financial updates on specific bond issuers at a Web site maintained by the Municipal Securities Rulemaking Board, a federal regulator of broker-dealers and banks that market, trade and underwrite municipal bonds: www.emma.msrb.org/default.aspx.