If the possibility of defaults has you leery of investing in municipal debt, consider pre-refunded or escrowed-to-maturity municipal bonds.
"In the muni bond market, both taxable and tax exempt on the pre-re and escrow side still give good yields," says Donald Cummings, founder and portfolio manager at Blue Haven Capital in Geneva, Ill.
Pre-refunded and escrowed-to-maturity municipal bonds are typically backed by investments in U.S. Treasuries and are considered fairly safe.
Here's how they work in a nutshell: A municipal bond issuer may decide it wants to refund a bond that investors already hold. Why? The bond may be too expensive or have unfavorable terms the issuer wants to shed.
It can issue a new bond and take the proceeds from selling it to buy Treasury securities, which are placed into an escrow account. Instead of Treasuries, they may buy Fannie Maes or Freddie Macs or other securities. The interest payments from the securities then go to pay interest on the outstanding old bonds.
In most cases, investors with bonds that are escrowed-to-maturity will continue to receive payments from the collateralized securities until their bonds mature. However, in some instances the bonds may be called early.
Investors of pre-refunded bonds will receive payments until the call date, at which point the bonds are called back and redeemed with the funds from the escrowed accounts.
With both the pre-refunded or escrowed bonds, the escrow account is used to pay both principal and interest.