investing

How to avoid municipal bonds that default

Revenue bonds can be issued to finance hospitals, airports, telecommunications infrastructure, industrial development, higher education and power plants.

"It's a very segregated income stream that you're counting on," says Marilyn Cohen, founder of Envision Capital Management in Los Angeles and author of "Marilyn Cohen's Bond Smart Investor."

Historically, general obligation bonds and traditional water-sewer revenue bonds have low default rates, but even there, investors must do their homework.

"If you buy essential-service revenue bonds, such as water and sewer, you're going to be fine. But it depends on the area because if you buy water and sewer bonds in areas that have a high foreclosure rate, you need those hookups to continue to keep that income stream rolling," Cohen says.

Yield goes with risk

While the majority of bonds in the municipal bond universe will be less risky, investors can get sucked in by high yields, and that is when things get tricky.

"You really have to be a professional to invest in that marketplace. An individual is much better suited to go into a mutual fund because a fund gives them a whole bunch of benefits," says Larkin.

The benefits include a professional investment team well-versed in the market, diversification and monthly payments. But that's not all.

"The most important thing that it gives them is liquidity. I always refer to (the municipal bond market) as a county road. The transactions are not very frequent, and liquidity can be a major problem because as a retail investor, you can get scared very easily and then try to sell. And that's when you're going to take your biggest loss," Larkin says.

Closed-end muni bond funds

The fact that the municipal bond market is so illiquid can make closed-end funds more attractive to investors who might not otherwise consider them. But there are some drawbacks to closed-end municipal bond funds.

For one, most use leverage, which can amplify returns or, conversely, show dramatic losses quickly.

"These leveraged funds can be down 15 percent in a week if there's massive selling," says Cohen. "It's not a passive investment: You have to be ready to eject when it's time to eject," she says.

Fees are another issue. They can be expensive, Cohen says. Investors should also try to buy them as close to the net asset value as possible or, better yet, below NAV.

Closed-end funds are traded on an exchange like stocks or exchange-traded funds, or ETFs. Unlike an open-end mutual fund, when the closed-end fund is created, a set number of shares is allocated, and the net asset value is established through an initial public offering. The difference between what people are willing to pay in the open market and the NAV indicates a premium or a discount.

Right now, there's a high demand for yield, so many of the municipal bond funds are trading at a premium.

"Stick with the big providers -- Black Rock and Nuveen -- the big, big providers. And stay away from some of these closed-end muni funds that are selling at huge premiums. Some of these premiums are 10 (percent) or 20 percent over net asset value," Cohen says.

The municipal bond market is complex and not without risk, and some sectors do have high default rates. But there's nothing wrong with taking risks as long as you understand them -- or if you have the right fund management team to understand them for you.

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