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Is there a muni bomb in your portfolio?

By David Ellis, staff writer

NEW YORK (CNNMoney.com) -- If the ongoing budget woes of the nation's cities and states don't make you nervous, perhaps it should.

Even if you live in a town that hasn't had its police force slashed or school budget cut, there's a chance that the problems faced by many local governments affect you.

Is buying bonds now a good investment?
  • Not for me, I look for higher returns.
  • Ive always diversified with bonds.
  • Im buying bonds now because of stock volatility.
  • Yes but only government-issued bonds.

As of the end of the first quarter, American households held more than $1 trillion, or more than a third, of the $2.8 trillion in outstanding municipal bonds, according to figures published last week by the Federal Reserve.

That number, of course, doesn't just represent government debt. It also includes bonds issued to pay for roads, sewers, hospitals and other public projects. This illustrates just how exposed mom-and-pop investors are to local economic troubles.

Municipal bonds have always been a popular choice for many Americans. Not only do they offer a tax-free return to investors, they have long been recognized as one of the safest places to put your money.

Municipal bonds started to lose some of their luster in recent months however, as soaring unemployment and falling property values took a bite out of tax revenues.

Credit rating agencies have cut their ratings on seven U.S. cities so far this year. There are fears that several of those, including Central Falls, R.I. or Harrisburg, Penn., could tip over the edge, making their bonds virtually worthless.

"It is reasonable to expect a few cities will get into trouble or perhaps default," said Matt Fabian, a senior analyst at Municipal Market Advisors, an independent municipal bond research firm.

Thus far, rumblings in the muni market have remained rather muted. Still, that has been little consolation to some of the nation's top investors. Earlier this month, Berkshire Hathaway chief and billionaire Warren Buffett warned that he anticipates municipal debt woes will become a "terrible problem" in the future.

Industry trackers like Fabian agree that the government budget crisis epidemic may have a few more years to play out. Still, he and other experts are reluctant to say that the portfolios of everyday investors are poised to take a major hit.

Even if there is a spike in the number of local governments defaulting on their debt, default rates would have to climb pretty high to make much of a dent.

Historically, less than half a percent of investment-grade municipal bonds have defaulted over a five-year period, according to Moody's.

What is also comforting is the fact that many of these municipalities have more options than a cash-strapped consumer or business. Many cities have some flexibility to cut and tax their way out of their problems.

"Governments have a greater array of tools," said John Miller, chief investment officer of Nuveen Asset Management, which oversees approximately $74 billion in fixed-income securities, much of which is made up of municipal bonds. "They really can't go out of business unless the city is totally unviable." To top of page

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