On one level, munis are certainly cheap,
even after the spirited rally they’ve put on since
mid-December.

Normally, bonds issued by state and
local governments yield less than Treasuries of the
same maturity. Reason: Muni interest is exempt from
federal income tax.

Yet the Bond Buyer Index of long-term municipals recently yielded 5.6%, versus
3.8% for the longest-dated Treasury bond. If yield
were the only consideration, munis would rate a
screaming buy.

A Complex Question

But it’s not that simple. For one thing, the global
financial crisis has driven Treasury yields into the
basement. Investors around the world, in a “flight
to safety,” have piled into Uncle Sam’s paper, even
though our government is issuing enormous amounts
of debt.

Once the panic passes, Treasury yields will
spike — especially as folks recognize the inflationary
impact of all the money the Federal Reserve is
creating to sop up the government’s bonds.

In short, there’s an unreal aspect to Treasury
yields right now. It makes more sense to compare
other investments (such as munis) with their
own history, rather than with Treasuries. By that
yardstick, muni yields aren’t so far out of whack —
only about half a point above their average of the
past five years.

Then there’s the elephant in the room: The risk
of default.

Since 1970, only about 0.1% of munis
have failed to pay principal and interest on schedule.
However, defaults have picked up sharply in the
past 12 months. In 2008, a record $7.5 billion worth
of bonds defaulted.

If the economy remains in the
dumps or worsens, many more munis will run into
financial difficulty. And bond insurance may not
bail out investors, because most of the insurers who
purport to back municipal bonds are themselves on
the ropes.

I’m not particularly worried about most state
governments. But I’m watching the California
budget charade with some unease. Over the long
run, the Golden State can’t hope to balloon its
debt 22% a year (as the new budget contemplates).

Other states whose finances look bleak at the
moment include Michigan, Nevada, Illinois, Ohio,
Florida and New Jersey. Ditto for Puerto Rico. If
you’re a resident of any of these latter jurisdictions,
you should keep an eye on budget developments
at the capitol. A swing toward dramatically higher
state borrowing could signal rising default risk
down the road.

Of greater immediate concern are the…

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Of greater immediate concern are the legions
of “revenue” bonds issued by quasi-state agencies
on behalf of hospitals, colleges, airports and other
self-supporting organizations. As the name implies,
owners of these bonds can’t turn to the taxpayer
for help; principal and interest are paid out of the
organization’s revenues.

Given this added risk, I
would sell any individual revenue bonds issued by
the seven states listed above (or their subdivisions).

Favor Funds Over Single Bonds

More broadly, I think this is a time to avoid
buying individual muni bonds, even from financially
healthy states. Individual munis are always difficult
to sell at a reasonable price, and a dealer’s bid price
(i.e., the price you would get if you decided to sell)
can collapse if an individual issuer hits the skids.

For new money, I suggest tax-exempt mutual
funds instead. With a no-load fund, you can sell
anytime at the fund’s net asset value. This type of
liquidity is precious beyond words in today’s world,
where events from left field can hammer even
seemingly safe investments.

My #1 sponsor of no-load muni funds is
Vanguard. Not only does Vanguard consistently
charge the lowest fees among bond funds, but you
can also rely on the Vanguard management team
to do careful credit analysis on the bonds they
purchase.

At this point, I would favor Vanguard’s national
muni funds, rather than the single-state funds, for
fresh cash. Geographical diversification (safety) is
more important than getting an exemption from
state income tax on your interest.

In addition, I would steer toward intermediate
maturities rather than long-term bonds, just in case
the mania for Treasuries reverses abruptly, with
a spillover effect on long-term munis.

Your Best Best

Vanguard Intermediate-Term Tax-Exempt Fund (VWITX; 800/662-7447, $3,000 minimum), which
features an average maturity of 6.9 years. Current
yield: 3.49%. Monthly distributions.

Munis still have a role to play for investors in the
top federal tax brackets (28% or above). But they’re
not a freebie. Look before you leap.

Richard E. Band, editor of Profitable Investing, is the newsletter world’s #1 authority on investing for low-risk growth. His flagship Total Return Portfolio has tripled in value since its inception in 1990, while taking far less risk than the popular stock market index funds. Through good markets and bad, his recommendations for conservative investors have grown 798% since 1984. For details on how to join Profitable Investing risk-free for six months, click here now.