Municipal Bond Reports: High Net Returns and Low Default Risk

It's not exactly a secret that states are in a severe budget squeeze. And that logically raises the worry meter for your municipal bond portfolio. But there's plenty of evidence to suggest that the rewards outweigh the risks.

While it's easy to jump to the conclusion that the fiscal straits of state and local governments could trigger a rash of muni defaults, that would be a sharp reversal of long-term history. A recent Vanguard report points out municipal bonds have been incredibly resilient over the past four decades:

Among more than 18,000 muni bonds rated by Moody's Investor Services during the 40 years-and 5 recessions-from 1970 to 2009, only 54 issuers defaulted, mostly in the housing and healthcare sectors. The average 10-year cumulative default rate was just a fraction of 1%, compared with a default rate of about 11% for corporate bonds.

While today's budget woes definitely make municipals riskier than during flush economic times (remember those?), that long-term default history suggests that issuers have been adept at making their way through rough fiscal stretches without reneging on their bond payments.

At the same time, I'm betting that higher taxes are a question of when, not if, for higher income earners. (You know who you are by now, right? Couples with income over $250,000 and individuals with income over $200,000.) When that kicks in, tax-free income will become even more valuable.

The Real Municipal Bond Payoff
But perhaps the most compelling argument for municipal bonds is their performance relative to other pockets of the fixed income universe. Check out the chart below, from Thornburg Investment Management. (PDF) It shows the difference between nominal (gross) returns and what the firm calls "real real returns" that have been adjusted for inflation, taxes and expenses over the past 30 years.

Source: Thornburg (PDF)

This is a classic case of It's Not What You Make, It's What You Keep. While the nominal return of municipals wasn't anything to write home about, once you net out taxes, inflation, and expenses, munis were in fact the best asset class within fixed income.

Now all that said, there is no denying you need to be extra careful in how you invest in municipals these days. This Moneywatch article lays out municipal bond investing tips. And don't miss the advice Jane Bryant Quinn and Larry Swedroe have for successfully navigating the muni market.

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