By Dan Weil • Bankrate.com

Investing » Municipal Bonds: Investing Pros And Cons

Municipal bonds represent an attractive investment for individuals looking for assets that provide tax-advantaged income.

Interest payments from muni bonds aren’t subject to federal taxes. If the bonds are issued by the state in which the investor resides, they’re free of state taxes. And if they’re issued by the city in which the investor resides, they’re free of city taxes.

For clients in high tax brackets, munis can be superior to other fixed-income options, says Tim Ghriskey, co-founder of the Solaris Group in New York City.

Munis generally make sense for investors in the 25 percent federal tax bracket and higher, financial advisers say.

Prophets of doom

The financial crisis of 2008 and 2009 and the ensuing economic malaise wreaked havoc on state and municipal finances, leading investment luminaries, including Warren Buffett, to say a catastrophe in the muni market is likely at some point.

Most famously, in December 2010, Meredith Whitney, who leapt to fame by correctly predicting the banking meltdown, issued an ominous forecast for munis on CBS’ 60 Minutes. She predicted that 50 to 100 municipalities would have significant municipal bond defaults in 2011, totaling hundreds of billions of dollars.

That never happened. Many states and municipalities have cleaned up their finances in recent years. State tax collections increased for each of the past four years, though they slipped 0.3 percent in this year’s first quarter, according to the Rockefeller Institute.

While Detroit filed for bankruptcy in 2013 and the U.S. territory of Puerto Rico is struggling with its municipal debt, the S&P Municipal Bond Index had a default rate of just 0.11 percent in 2013. Only 23 of more than 21,000 issues defaulted.

Default rates tend to be low, which has remained the case, even in a tough environment, despite some predictions to the contrary, says Miriam Sjoblom, former associate director of fund analysis at Morningstar, a research firm in Chicago.

Still, the fact that there haven’t been many defaults isn’t to say there may not be more, says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Connecticut. That’s something any investor has to be aware of.

Ghriskey concurs. Certain municipal bonds carry risk, he says. You have to do your homework. There are definitely states where bonds carry more risk.

Individual bonds vs. funds

If that doesn’t scare you away, one of the first questions for investors in munis is whether to buy individual bonds, mutual funds or exchange-traded funds, or ETFs. The advantage of buying individual bonds is that you’ll get all your money back at maturity, assuming the issuer doesn’t default. By contrast, with mutual funds and ETFs, you could suffer unrecoverable losses.

But most individuals don’t have the capability to thoroughly analyze individual bonds. It’s more difficult than corporate bonds, where balance sheets are easier to evaluate, Sheldon says.