Municipal bonds are issued by cities and states and can be either taxable or tax-free.
Upside: Municipal bonds typically pay higher yields than Treasuries or bonds from agencies such as Fannie Mae. Some municipal bonds pay tax-free interest income, a major benefit for bondholders in the 25 percent-and-above tax bracket, says Richelson.
Downside: Municipal bonds don't carry the same guarantees against default that a Treasury bond does. Some issuers of municipal bonds are considered at risk of bond default because of a combination of tax revenue losses from the recession, political gridlock and doubts about the ability of bond insurers to cover potential losses, Loeper says.
Also, the ratings agencies charged with rating the safety of municipal bonds proved to be ineffective during the recent financial crisis. That raises doubts about how well ratings will help investors judge the quality of municipal bonds in the future, says Loeper.
Bottom line: States and cities in good financial shape can offer a respectable, tax-free yield with relatively low risk on their longer-term bonds, but do your homework on a municipality's financial health before investing, says Richelson. He recommends bonds from the state government of Virginia.