How to invest in municipal bonds

(Money Magazine) -- Why have municipal bond funds been taking such hits in recent weeks? And what should investors do about it? -- Frank Manfredo, Brentwood, N.Y.

The reason behind the recent turmoil and carnage in the muni bond market boils down to one word: fear.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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Many states, including biggies like California, Illinois and New York, are dealing with severe budget shortfalls, raising concerns that states as well as cities could have trouble meeting their obligations to muni bond holders.

One well-known investment strategist, Meredith Whitney, even predicted on 60 Minutes last month that we could see upwards of 50 to 100 muni bond defaults around the country this year.

So fears of default alone have helped drive up muni yields and drive down muni bond prices.

At the same time, anxious investors reacting to those worries have been deserting muni bond funds in droves, pulling a net $20.9 billion out of muni funds in November and December alone, according to Morningstar.

That selling has exacerbated the downward pressure on muni bond prices, with the result that some muni investors have suffered double-digit losses over the past three months.

So it's no surprise that muni bond fund investors, besides feeling shell shocked about what's happened the past couple of months, are also anxious about what may lie ahead.

Unfortunately, neither I nor anyone else has a crystal ball that can foretell the future. But by taking a look at what's happened during muni market turmoil in the past and by applying some investing common sense, I think investors should be able to take appropriate precautions and set a reasonable strategy for the future.

First, a bit of perspective. I certainly don't want to downplay the seriousness of the problems facing the muni market. At the same time, though, while predictions of Armageddon are titillating, they don't necessarily jibe with past experience in the muni market.

Defaults are far from common: there have been just 54 between 1970 and 2009 out of 18,000 muni issues, according to Moody's Investors Service. Even when defaults have occurred, investors typically recover most of their money.

Also, it's not as if we haven't had muni selloffs before. In 2004, long-term muni funds lost roughly 6% of their value from early March through mid-May, and as the financial crisis unfolded in 2008, muni funds suffered losses of about 10% the last four months of that year.

In both cases, the market recovered relatively quickly. Muni funds got back to even by the end of the year in 2004, although it took until the end of July 2009 for muni funds to climb out of the hole they fell into in late 2008.

That doesn't mean that things couldn't turn out a lot worse this time. You only have to look back to the housing market's unprecedented collapse after peaking in 2006 to realize that the future doesn't always unfold like the past.

Given the possibility that the turmoil of recent months could continue or even worsen, I think it pays to take due precautions if you own munis or are thinking of buying them.

So what specifically should you do to protect yourself? Start by re-assessing how much of your wealth you have in municipal bonds. Some investors, particularly retirees hungry for tax-free income, stash all or nearly all of their savings in munis.

But having virtually all of your money in any single type of investment can be dangerous. If for no other reason than you don't want to be totally dependent on the health of the municipal bond market, make sure your fixed-income holdings are diversified.

That means owning some Treasury bonds, investment-grade corporates and even some CDs (which, for tax efficiency, you might hold in tax-advantaged accounts like a 401(k) or IRA.) Granted, expanding into these areas won't totally insulate you from risk and might also mean giving up some after-tax yield.

But the point is you don't want all your money sitting in one sector. To the extent you do hold munis, you want to be especially mindful of two particular risks: the risk of an issuer defaulting (credit risk) and the risk of your investment losing value because of rising interest rates (interest-rate risk).

To protect against credit risk, concentrate on funds that keep most of their portfolios in high-quality issues, say, AA or higher. You can check out the credit quality of a bond fund's portfolio by plugging its ticker symbol into the quote box at the top of any Morningstar page and then clicking on the Portfolio tab in the page that pops up.

You'll get a breakdown of the portfolio by bond rating (below B through AAA, plus the percent not rated), as well as how that breakdown compares with other muni funds.

For further protection on the credit-risk front, I'd suggest sticking mostly, if not entirely, to national muni funds, as opposed to ones that focus on a single state. This way the performance of your muni portfolio isn't tied to the fortunes of just one state.

When it comes to interest-rate risk, bonds with the longest maturities are most vulnerable. So to shield yourself against a big hit, the best course is to limit your exposure to muni funds that concentrate on long-term muni bonds and favor ones that hold short- to intermediate-term securities.

At the bottom of the Portfolio page I mentioned earlier, you'll find a breakdown of a fund's portfolio by maturity. And at the top of that page, you'll find a fund's duration. This handy little measure of a fund's sensitivity to interest-rate changes can give you a rough sense of how much you might lose in a particular fund if rates rise.

For example, if a fund has a duration of six years, its price will drop approximately 6% if interest rates climb by one percentage point. If the fund has a 4% yield, that means you would be looking at a loss for the year on a total return basis of about 2% (4% yield minus 6% price loss).

If you click on the Ratings & Risk tab, you'll find other measures of a fund's riskiness, including its standard deviation (essentially how much its return bounces around its average return) and a Morningstar bear market percentile ranking, which shows how a fund fares relative to its peers when the bond market sours.

I also recommend that you favor funds with low expenses. What, you may ask, does this have to do with risk? Simple. Expenses reduce dollar for dollar the amount of yield a fund can pass on to its shareholders.

So in order for a high-expense fund to match the yield of a low-expense fund, the more expensive fund must invest in higher yielding, and thus riskier, issues. Or, to put it another way, a low-fee fund can provide the same yield as a high-fee fund with less risk.

You can check out a fund's expenses and see how they stack up vs. similar funds by clicking on the Expense tab. By the way, you can screen for funds that have low expenses as well as other features that mitigate risk (high credit quality, low duration) by going to the free Basic Screener in Morningstar's Tools section.

One final note: Although munis have attracted a lot of attention lately, the fact is that the bond market overall has gotten a lot dicier in recent years.

So for a big-picture view of bonds as well as advice on how to handle other areas of the bond market, I suggest you take a look at my MONEY colleague Paul Lim's feature story on bond investing that appears in MONEY's January-February 2011 Investor's Guide issue.

Who knows, maybe all the publicity about local governments' budget woes will spur efforts to resolve these problems and make the moves I've suggested unnecessary. Better to be prepared, though, in case that doesn't happen.