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Back in the Comfort Zone

Although it's supposed to be a relatively safe haven, the municipal-bond market has taken some big hits lately. The economic slowdown has thrown state and city budgets out of whack as revenues fall far short of spending plans made just a year ago. Credit agencies have been downgrading municipalities, especially big borrowing states like California and New Jersey. And localities everywhere are pumping out new debt to tide them over.

Against this background, it's important to stick to top-quality bonds. That's not hard because half of all munis carry a triple-A rating. The vast majority get that rating because they are insured, which guarantees investors timely payment of interest and principal even if the issuer defaults. The four largest muni bond insurers--Ambac, Financial Guaranty Insurance, Financial Security Assurance, and MBIA--are sound companies and have paid claims in the few instances when issuers have defaulted, says Howard Mischele, a director at Standard&Poor's.

Since muni bond issuers rarely default, is insurance overkill? No, since insured bonds should hold their value better if an issuer's credit rating drops. With most states facing budget deficits, a few more credit downgrades are likely this year. States that S&P is monitoring for possible credit-rating cuts include Arizona, California, and Colorado.

Insured bonds have other pluses. It is easier to compare the credit quality of insured bonds. Also, they trade more actively than other munis, so investors can more easily buy and sell them. Insured muni bond funds are a different story: Morningstar analyst Eric Jacobson says they tend to offer slightly lower yields while charging above-average expenses. Because a fund manager closely monitors the credit quality of holdings, insurance is less of an issue.

To further protect yourself, Mary Miller, who heads muni bond investing at T.Rowe Price, suggests sticking to bonds backed by user fees for essential services, such as water and sewage. Conversely, you may want to skip bonds backed by sales taxes, since revenues from that source shrink during economic downturns, she says.

Mark McCray, head of muni bond investing at PIMCO, says investors often overlook the importance of having a geographically diversified portfolio. True, it makes sense for a resident of a high-tax state like California or New York to load up on the bonds of their localities because they can then qualify for an exemption from federal, state, and, if applicable, city taxes. By putting a slice of your portfolio in a national muni bond fund, however, you guard against an unforeseen disaster such as a major earthquake in California (table).

It seems prudent to stick to the shortest maturities since the the Federal Reserve is expected to raise interest rates later this year. But Marilyn Cohen, head of Envision Capital Management, a bond investment firm in Los Angeles, says that with munis maturing in a year yielding 1.6%, the strategy isn't lucrative. She believes the best deal now are issues maturing in 10 years, which recently yielded 4.10% vs. 3.25% for five years. With the federal tax exemption, that 4.10% yield translates into a juicier 5.86% for an investor in the 30% marginal tax bracket.

It's rare for an investment nowadays to provide decent yields and let you sleep at night. That's why munis belong in most portfolios. By Susan Scherreik

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