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Market still holds potential for investors

Investors have been flooding out of municipal bonds amid fear of defaults by troubled state and local governments. They've pulled $25 billion out of muni-bond funds in just over two months.

The question is whether they've overdone it.

Has an investment long viewed as an ultra-safe, plain-vanilla part of a portfolio really become that toxic?

Many bond market experts think investors have overreacted. At the very least, municipal bonds haven't lost their tax appeal.

Muni bonds are issued to help pay for projects such as schools, hospitals, roads and bridges. They're also called tax-free or tax-exempt bonds because they're exempt from federal taxes and most state and local taxes, which usually makes them a popular investment for taxpayers in high-income brackets.

Not lately.

Concerns about the fiscal health of state and local governments in the wake of a punishing recession are valid. States face $114 billion in budget shortfalls, and investors are wary of the potential for a rash of municipal bankruptcies and defaults. One warning already came from Harrisburg, Pa., which announced it was headed toward default on $3.3 million in bond obligations last fall, before it was bailed out by its bond insurer. How many more Harrisburgs are out there?

An even bigger alarm bell sounded in the $2.8 trillion market when Meredith Whitney, an influential financial analyst who heads her own firm, last month forecast the possibility of 50 to 100 sizable defaults in 2011 worth hundreds of billions of dollars.

Other concerns also have roiled the market. Most notable was Congress allowing the expiration of a program -- Build America Bonds -- that lowered borrowing costs for local governments.

All of these events spurred investors to withdraw a net $25.1 billion from muni-bond funds in the 10 weeks ended Jan. 12, according to the Investment Company Institute. That was after they attracted new cash every week dating back to last April.

The result was the worst quarter for tax-exempt munis in nearly 17 years. The value of general muni debt funds declined 4.6 percent from October through December, the biggest drop since the first quarter of 1994. And the slide has continued; through Tuesday, they were down 2.87 percent in January.

Although investors have to be cautious, munis' appeal hasn't vanished.

Here are five reasons not to fear the muni market:

1. Defaults are historically very rare.

Even after the economy and stock market tanked, there were just 10 municipal bankruptcy filings in 2009 and five last year, according to Bank of America Merrill Lynch.

Going back decades, defaults have been even more infrequent. Only 54 of 18,400 rated municipal bonds defaulted from 1970 through 2009, according to Moody's Investors Service.

2. Bonds tied to essential public services are particularly safe.

State and local governments can raise taxes as needed to pay off their general obligation bonds. And no city water, power or sewer provider is going to shut off such an essential service -- it will do what's necessary to avoid a default.

Default rates for general obligation bonds and municipal revenue bonds with strong credit ratings (A and above) are close to zero. A general obligation bond carries the extra protection of being secured by a state or local government's pledge to use legally available resources, including tax revenues, to repay bond holders.

3. Diversified funds should cushion any blow.

Although an individual bond might offer the best chance for a strong return, a safety-first investor should buy munis through a fund. Diversification smoothes the ride in a bumpy market.

The average investor doesn't have the experience or the assets necessary to diversify muni holdings. Experienced fund managers do, and are better positioned to avoid the most troubled bonds, says Miriam Sjoblom, a municipal bond fund analyst for Morningstar.

"Given the tremendous budget strain on many municipalities, this is a bad time for investors to have much money concentrated in a few municipal bonds," she says.

Choose a national fund that invests in high-quality bonds rather than a state-specific one, to be the safest.

4. The economy is improving.

Despite their fiscal challenges, U.S. municipalities are reaping more revenue in a strengthening economy. State and local governments collected $22 billion more in the first three quarters of 2010 than they did a year earlier.

Increasing tax revenue still isn't enough for the most strapped governments to meet all their obligations. But the general outlook for improved economic growth this year suggests a continued recovery in their finances.

5. Bargains abound.

Suddenly lower fund prices and higher yields present good opportunities.

A typical 10-year muni bond yielded 3.41 percent recently, compared with 3.3 percent for a 10-year Treasury. Because the muni is tax-free, that's the equivalent of a 4.74 percent yield on a taxable investment for someone in the 28 percent tax bracket -- a better payout than most other fixed-income alternatives.

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