Municipal bonds offer tax-exempt income but they have risks, too.
* Issuers face financial stress. Many states, cities, and other municipal bond issuers are suffering from lower income, sales, and property tax revenues.
* Obligations are rising. Some issuers of municipal bonds have steep pension obligations, which will increase in the future.
* Insurance has become rare. With expenses going up and tax revenues under pressure, some municipal bond issuers might default: not make the promised interest payments. In prior years, defaults might have been covered by insurance. Most municipal bond issuers have taken a beating in the financial crisis so coverage might not be available.
One possible solution is to own munis through a large, diversified municipal bond fund. Look for a fund where the average credit quality is AA or better, to assure yourself that you’re investing in highly-rated bonds.