Tax-exempt municipal bonds behave differently from Treasury bonds or corporate bonds. Besides the difference in tax treatment, munis are less volatile than other bonds, which helps dampen portfolio volatility.
In addition, munis compare favorably with corporate bonds, in terms of credit risk.
According to one study, municipal bonds are about ten times less likely to default than similarly-rated corporate debt.
In another study, covering the 30 years ending in 2004, overall default rates for investment-grade corporate bonds were almost 90 times higher than the rates for investment-grade municipal bonds.
The bottom line: if municipalities were rated like corporate bonds, the vast majority of general obligation debt issued by fiscally sound, large municipal issuers would get top ratings.
The catch? if a municipal bond falls below the investment- grade category, the risk of default increases 60-fold. Thus, investors should think carefully about investing in munis that are below investment grade.