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6 Safe Ways of Investing in Tax-Free Municipal Bonds

How safe are your municipal bonds? That depends on which ones you own. "Muni bond defaults are far more likely to default than at any time in recent history," says bond expert Alex Anderson, vice president of Envision Capital Management. Most of them will pay, but you have to buy them right.

The danger has been hiding in plain sight since early in the financial collapse, and I wrote about the risks myself back in May. This week, financial analyst Meredith Whitney, the first person to out Citigroup as a zombie bank before the market collapse, went public with a new warning: expect 50 to 100 "sizable" muni bond defaults -- hundreds of billions of dollars worth. "I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S economy," she told 60 Minutes.

The tax-free yields on municipal bonds have been great buys for investors in the 28 percent bracket and up. They yield more than comparable Treasuries after tax, and boast a storied safety record. Major defaults, however, would upend the market, even for high-grade issues. So how can you protect yourself? Here are six ways:

1. Buy pre-refunded muni bonds. They're as safe as Treasury securities, and yield more after tax.

"Pre-res," as they're called, are older, higher-rate bonds that the issuer wants to redeem. Redemptions aren't possible, however, until the bond's first "call date," which might be a few years away. So the issuer sells new bonds at a lower interest rate, puts the proceeds into escrow, and invests them in Treasury (and sometimes agency) securities. The interest on the Treasuries is used exclusively to pay the interest due on the older munis and redeem them at the earliest opportunity.

Refunding can turn any muni into an AAA-rated security - backed by Treasuries, not by the state or city that originally issued it. John Bailey, founder and CEO of Spruce Private Investors, a chief investment officer for affluent families and foundations, says that he sold his traditional munis two years ago and now owns only pre-res.

You'll generally need a broker to help you identify individual pre-refunded bonds. There's also an exchange-traded fund, Market Vectors Pre-Refunded Municipal Index Fund (PRB), introduced in February, 2009. It's small and lightly-traded, averaging only about 7,000 shares a day. In theory, it should be less volatile than other ETFs during a muni panic.

2. Reduce your holdings of general obligation munis (GOs) issued by the riskiest states. GOs are backed by the states' taxing power, but you have to ask yourself what taxing power? Voters are on strike. Some new governors plan to cut taxes rather than raise them, even in big-deficit states such as New Jersey. Dysfunctional legislatures -- think California, Illinois, and New York -- mud wrestle while their states fall apart.

Among the riskier states, Envision lists eight that couldn't afford to pay any more than one-third of their pension liabilities this past fiscal year: Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island, and West Virginia. For another perspective, read The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform, from The Pew Center on the States.

States aren't allowed to go bankrupt. They could default by failing to pay principal and interest on time. But they'll do almost anything to avoid it -- to the point of issuing billions in IOUs to other creditors, such as school systems, social service agencies, and small businesses. Illinois, for example, has run up $5.3 billion in unpaid bills, driving some firms out of business and forcing others to borrow money or lay people off. The bondholders, however, are being paid in cash.

Mostly likely, the federal government would step in to halt a major state default because of the damage it would do to the $2.8 trillion municipal market. That's why California, for example, has no trouble selling bonds, especially at the higher interest rates it's forced to offer. The main reason for warning you off state bonds is that, in a crisis, they'll plunge in value, which would hurt if you had to sell (or if you panicked and sold).

3. If you live in one of the riskier states, skip the GOs and buy revenue bonds backed by reliable income streams. Good revenue bonds can hold their value even if there's a budget scare. Likely candidates include sewer and water bonds that support needed services in well-established communities. Avoid bonds that depend on fees from nonessential services such as sports arenas and real estate developments.

Many municipalities sell "conduit" revenue bonds on behalf of non-profit investors such as hospitals. They have no government backing and default at a higher rate than other revenue bonds.

4. Go for high quality, if you're buying munis from counties, cities, and towns. They can all go bankrupt and that's where more defaults will arise. Most towns get at least one-third of their revenues from the states, Envision's Anderson says, and states are chopping aid. In 2009, the federal government helped fill the states' budget gap with $160 billion from the stimulus package. That ends in April, which is when the crunch begins. Holders of town GO bonds that default would probably get their money back, but not right away. Municipalities are likely to pay pensions and salaries first, while putting the bondholders on ice.

5. If you have only a modest amount to invest, and live in a risky state, diversified bond mutual funds remain a reasonable choice. Choose a high-quality fund that invests in the bonds of many states, and rely on the manager to keep you out of trouble. Your state will probably tax the interest on out-of-state munis, but you'll carry less default risk. Alternatively, try the Pre-re ETF.

You will still have market risk, however. Rising long-term interest rates threaten every type of bond fund. That's because when rates rise, bond prices decline. Municipal Market Advisors reports that November's muni bond index performance was the worst since 1993 -- losing almost 3 percent. Investors in bond funds will earn more income, thanks to the higher yielding munis the fund managers will be able to buy, but will lose money if they have to sell shares. If losses alarm you, switch to high-yielding certificates of deposit.

6. Get out of the game, and buy corporate bonds instead of munis. "I never thought I'd say this, but corporates are a safer place," says Envision founder Marilyn Cohen. There's tons of cash on their balance sheets, they've paid down high-interest debt, and improved their debts' maturity schedule. You pay taxes on the interest, but Cohen is philosophical. "In the end, you'll say to yourself, 'I paid extra taxes but at least I weathered the storm.'"

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