Municipal bonds and muni funds remain a source of concern for investors. Baby boomers and retirees like the tax-free income but significant risks remain. Although we like to think that a municipal bond fund balances those risks out through diversification, some funds apparently are doing a better job than others at managing risk.

Current Municipal Bond Fund Risks

Lets start with the fact that in general, state and local governments are in terrible financial shape. For example, Moodys Investors Service recently assigned a negative outlook to the entire state and local government sector. Thus, even if you own a muni bond or fund that is backed by the general government taxing authority, your comfort level has to be falling.

As one problem example, take Stockton, California, a bedroom community. It is anticipating a $30 million budget deficit this year.  77% of its revenues are used to pay police and firefighters. However, sales taxes are dropping rapidly because the unemployment rate is at 16%. Property taxes are also falling because home prices are down 60% compared to 2006. There is a good chance that Stockton will default on its bonds because unions are seeking legislation that will protect their union contracts.

A second risk is that insurance companies that have traditionally insured municipal bonds have all but disappeared. Those that remain are financial question marks unto themselves. To give you an idea, in 2006 56% of the muni bonds issued were insured. That has fallen to 13% for bonds issued in 2009.

Third, a lot of the municipal bonds owned by funds are in severe jeopardy of defaulting because they are backed by projects and revenue sources that are failing. The worst risks are probably with dirt bonds and tobacco settlement revenue bonds. Dirt bonds are backed by specific real estate development projects sponsored by local governments. Many of those projects are half-built and may not be completed. Tobacco settlement bonds are backed by revenues paid by tobacco companies. As the federal and state governments increase tobacco taxes, the safety of those revenues generated by sales of cigarettes decreases.

Low Risk Municipal Bond Funds

Some muni bond fund companies have done better than others in managing risk. One example of a poor job is with Oppenheimer funds.  Twelve OppenheimerFunds tax-exempt funds, with assets of $25 billion at the end of 2007, lost 30% to 48% in 2008. Oppenheimer fund managers seemed to like dirt bonds and those did some real damage to the fund valuations. As a result, investors have sued and accused Oppenheimer of concealing the true risks with the funds.

Here is a chart of some high risk and lower risk municipal bond funds compiled from data published by Forbes, Lipper, and Morningstar.