Municipal bonds safe bets?

You might be able to make good money from municipal bonds — if you can stomach the risks. Let’s start with greed and move on to fear. You don’t normally associate greed with a municipal bond, which is a long-term IOU issued by states and other local government entities. Munis pay regular interest and return your principal at maturity. Interest from municipal bonds is free from federal taxes; if you live in the state that issues the bond, interest is free from state and local taxes as well.

Currently, long-term California municipal bonds backed by the state’s taxing authority — the strongest guarantee a state can offer — yield 5.8%. A 30-year U.S. Treasury bond yields 4.55%.

You might not think a 5.8% yield is all that tempting. But suppose you lived in California, where the maximum combined state and federal tax rate is 44.5%. You’d need to earn 10.45% in a fully taxable bond to keep 5.8% after taxes.

Because investors worry about default risk, muni yields have risen. That’s not necessarily a good thing. A bond never changes the interest rate it pays. If you own a bond that pays $50 a year in interest, it will pay $50 in interest until it matures.

A bond’s yield is its interest payment divided by its price. As a simple example, a $1,000 bond that pays $50 in annual interest yields 5%. To push up the yield, traders whack the price. Chop the bond’s price to $900, for example, and its yield will rise to 5.6%.

Bond traders use a more complex calculation called yield to maturity, but you get the idea. As the odds of default rise, traders push down a bond’s price and push up its yield. You’re getting high muni bond yields because the odds of default have risen.

So far, we’ve been talking about muni bonds backed by state taxing power, or general obligation bonds. Other municipal entities, such as towns, universities and airports, may have lower credit ratings. Those with the lowest ratings are called high-yield muni bonds. Like high-yield corporate junk bonds, high-yield munis have high yields because they have greater credit risk.

But the default risk of a high-yield muni is considerably less than a corporate high-yield bond. Municipal bankruptcies are extremely rare. Corporate bankruptcies? Not so much.

Should the economy improve, muni bond prices, and particularly high-yield muni prices, should rise, too. Bear in mind, however, that rising interest rates hurt bond prices, too. In the normal course of events, a healthy economy produces higher interest rates.

So if you’re looking for high, tax-free yields, be aware that you’re taking on a fair amount of risk — but not as much as you’d be taking with stocks or corporate junk bonds. The next few months are likely to be rocky for the muni market, and particularly the high-yield muni market. If you sob when your fund’s share price falls, it’s not for you.

On the other hand, if you can tolerate some risk and need income, a muni fund — or a high-yield muni fund — might not be a bad idea. (Buying individual bonds is best left to the pros.) The top high-yield muni funds are in the chart. A small allocation might help keep the buzzards at bay.