With budget woes a daily news staple, state and local governments are taking steps to address the issues. Amid this uncertainty, it's important to understand some truths about investing in munis:

* Defaults are low.When states face severe budget deficits, some investors may shy away from state-issued municipal bonds. Unlike companies, however, state governments cannot go out of business. Most states are required to balance their budgets each year, and debt is usually at the top of their budget priorities. Since any default would taint a state's name in the public-debt markets and significantly increase the cost of borrowing, states aim to avoid defaults.

Even when a default has occurred, all is not lost. Among the limited number of defaults by rated municipal issuers (54 according to Moody's, from 1970 to 2009), the average recovery rate was 67 cents on the dollar. When investors remember that the historical default rate for rated municipal bonds has been less than 1%, according to Moody's Investors Services (as of February 2010), the current municipal bond market is far less daunting.

* Income is important. Over the long term, income has historically contributed much more to municipal bond total returns than price appreciation, according to Barclays Capital (as of June 30, 2010). Over the short term, income has helped cushion overall municipal bond total returns when prices declined.

Although prices of municipal bonds declined in nine of the 20 calendar years through 2009, the bonds' income helped offset the price movements. According to Morningstar (as of Dec. 31, 2009), in only three of these 20 calendar years did municipal bonds experience negative total returns when taking income into account.

* Choices are staggering. The municipal bond market currently includes approximately 50,000 issuers and roughly two million outstanding issues as reported by SIFMA (as of March 31, 2010). Investors in municipal bonds must carefully evaluate individual bonds based on various factors.

Take sectors, for example. Each sector within this market is subject to different risks and pressures. For instance, hospitals generate a significant portion of revenues from Medicare and Medicaid. In contrast, general obligation bonds are secured by the issuer's power of taxation. Thus, an AA-rated hospital bond does not necessarily represent the same credit quality risk as an AA-rated general obligation bond.

Against this complex backdrop, a strong research team can identify opportunities as well as potential pitfalls. Municipal bond funds are a way to access this expert research and diversify a portfolio.

 

Sheila Amoroso is senior vice president and co-director of Franklin Templeton Fixed Income Group's municipal bond department.