Watch over your municipal bonds

During these turbulent times in the stock market many investors have run to the safety of bonds, including municipal bonds. Generally bonds have a much lower risk of loss than stocks, but they still require some due diligence to be sure you’re making a wise purchase.

Municipal bonds are issued by states, counties and local governments. They are a little riskier than government bonds because they don’t have the backing of the federal government. One of the features that makes them more attractive however is that they are federally tax-free, and if you buy munis issued by your home state they are also state tax-free. Default rates for munis are historically very low, around 0.5 percent overall, but should not be overlooked as a risk. California recently issued IOUs to vendors to conserve cash and avoid default on its debt.

You should consider the financial condition of the issuer before buying a bond. One way you can do that is by looking at the bond’s credit rating. A high credit rating is not a guarantee that a bond won’t default, but is one indication of financial stability. It may also simply reflect that the issuer bought insurance to protect the bond payments. Certainly a low credit rating is a sign of financial instability. You will earn a higher interest rate for taking a chance on a low-rated bond but you run a higher risk of default. The highest quality munis have an average default rate of less than 1 percent; the lowest rated bonds almost 17 percent.

Another way to research a new bond is to read the official statement, which outlines the details of the bond. These are available through the Municipal Securities Research Board (MSRB) via EMMA, the electronic municipal market access system. As of July 1st you can now also search their database for continuing disclosure statements on bonds issued since 1990. EMMA also has information on 529 plans, because they are run by states.