Municipal bond fundsHow they're valued: Municipal bond funds invest in a number of different municipal bonds, or munis, issued by state and local governments. Earned interest generally is free of federal income taxes and also may be exempt from state and local taxes.
Risks: Individual bonds carry the risk of default, meaning the issuer becomes unable to make further income or principal payments. Cities and states don't go bankrupt often, but it can happen. Bonds also may be callable, meaning the issuer returns principal and retires the bond before the bond's maturity date. This results in a loss of future interest payments to the investor. Fortunately, bond funds spread out potential default and prepayment risks by owning a large number of bonds, thus cushioning the blow of negative surprises from a small part of the portfolio.
Liquidity: You can buy or sell your fund shares every day. In addition, you usually can reinvest income dividends and make additional investments at any time.
Pros and cons: Bond funds offer greater diversification, liquidity and professional management when compared to individual bond purchases. However, unlike with individual securities held to maturity, the share price of bond funds fluctuates daily with interest rate changes.
Wealthier investors living in states with high taxes sometimes are attracted to munis because they help reduce an investor's income-tax burden. Some investors find they earn more from tax-free municipal bond funds than from a comparable taxable bond fund, despite the lower average yields of munis. Bankrate's Tax Equivalent Yield Calculator can help you determine your tax-equivalent yield on munis. When buying or selling muni bond funds through a brokerage firm, watch out for brokerage fees.
Where to find them: Muni bond funds are available at brokerage houses and mutual fund firms.
Caveats: At least 47 states faced or are facing budget shortfalls in 2009, according to the Center on Budget and Policy Priorities. While this doesn't necessarily mean these states' bonds will go into default, investors need to pay close attention to the financial health of the cities and states associated with these bonds -- a job best left to expert money managers.
Year-to-date through May 31, municipal bond funds that include high-yield muni bonds (also known as junk bonds) gained 9.07 percent, while those that exclude the lower-grade bonds gained 8.52 percent. Over one year through May 31, the bonds that contain junk lost 0.15 percent, while those that don't gained a meager 0.66 percent, according to Morningstar.
Words of caution: "There's always a handful of companies that may be having some cash flow problems or trouble meeting debt obligations, and it's no different with munis. You have to look at which municipalities have more risk than others. Using a fund manager in this case, instead of investing in munis on your own, makes a lot of sense because you are using a professional manager to sift through all that information and understand which municipalities pose a greater risk than others. If something goes wrong with one of those municipalities, the risk is somewhat minimized because of the huge number of holdings in a municipal bond portfolio. Defaulting doesn't happen that often in municipalities, but if it does, your exposure to that is limited." -- Scott Donaldson, investment analyst, Vanguard Investment Strategy Group, Valley Forge, Pa.