Municipal bonds: Investing pros and cons

Again, Ghriskey agrees. "It's a market where investors can benefit from professional advice, as long as the advisers are experienced and don't charge too much," he says.

Furthermore, buying individual muni bonds can be quite expensive. You can purchase them from discount brokers, but the trading commission is baked into the price rather than charged separately. So you really don't know what you're paying in commissions. And brokers aren't eager to provide bargains, especially to investors buying bonds in small denominations.

Michael Dixon, director of planning and wealth management at financial advisory firm Carl Domino in Palm Beach, Florida, views $25,000 as the minimum size that makes sense if you want to buy individual municipal bonds.

And he says you'd want at least 20 different issues to gain adequate diversity. That amounts to a minimum of $500,000 in total. His firm calls three different bond brokers when making a purchase to ensure it receives a fair price.

ETFs or mutual funds?

For those choosing muni bond funds, Dixon recommends ETFs over mutual funds. "Expenses are lower for ETFs, and they are more transparent. With mutual funds, holdings information is updated just once a quarter," says Dixon of Carl Domino Inc. Most ETFs are based on an index, so their holdings don't change much.

In addition, "we like the diversification you get through ETFs, particularly if there are states that have financial issues," Dixon says. His firm now favors funds with medium-term maturities -- five to 10 years -- so its clients can attain decent yields without being vulnerable to large losses of principal when the Federal Reserve finally raises interest rates.

The average expense ratio for a muni ETF is 0.3 percent, compared to 0.98 percent for an open-end muni mutual fund, Morningstar says.

But Sjoblom says mutual funds carry some advantages over ETFs. While ETFs are based on an index, mutual fund managers can choose their holdings as they see fit. And while some mutual funds are risker than ETFs, ETFs can have credit issues, too.

Moreover, "where liquidity is not that high, inefficiencies can be in favor of the active manager versus the indexer," Sjoblom says. "There have been sizable differences between the value of ETFs and their underlying indices."

In choosing a muni bond mutual fund, you want to start with ones that have a history of success. Sjoblom advises looking at how a fund has performed in periods of distress, such as 2008. And she recommends looking for funds with below-average expenses, as there are plenty of good ones available.


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