After Detroit went bankrupt in 2013, some investors are more hesitant to invest in municipal bonds than in the past. In recent months, there has also been a lot written about the status of the muni bond market, with the information provided indicating that there could be more trouble brewing. That’s likely true, but only to a certain extent.

The municipal bond default rate in 2014 was a miniscule 0.17%. This was higher than the 0.11% default rate in 2013, but it’s still not something to panic over. Put it this way: if someone told you that you could own a stock with a 99.83% chance of success, even though the return would be low, it would probably pique your interest. However, there’s a catch with municipal bonds. The odds of your success will be even higher, or perhaps much lower, based on your research. (For more, see: How Stable Are Municipal Bonds?)

How to Pick a Bond

If you want to own a municipal bond without having to worry, then look at states, counties, and cities that are on the rise. Is the location seeing population growth? If it’s a city, does it have a thriving downtown? Is it a popular tourist destination? On the other end of the spectrum, you want to avoid areas that are seeing declining populations and a lack of revenue generation. General obligation bonds need the former for tax revenue, and revenue bonds need the latter to generate project revenue.

When you’re looking at municipal bonds, keep in mind that general obligation bonds tend to be safer because taxes can be raised to pay bondholders. General obligation bonds, or GO bonds, have lower yields than revenue bonds, but that shouldn’t be looked at as a negative if capital preservation is your top priority. If you’re looking to invest in city GO bonds, then only consider cities with populations of at least 10,000. Also make sure the population has been on the rise over the past several years. You might find higher yields on revenue bonds, but they also present higher risk because they act as businesses with revenues and expenses. They must rely on income-producing projects to generate revenue in order to pay bondholders. Revenue bonds are usually sold in $5,000 units and mature between 20 and 30 years.

If you want a head start from a location perspective, then you should avoid areas that are tied to the following industries: coal, steel, iron, fracking, and manufacturing in general. Think of Scranton and Erie, Pa.; Cary and Hammond, Ind.; Charleston, W.Va.; Decatur, Ill.; Shreveport, La.; Saginaw, Mich. and many more. (For more, see: The Basics of Municipal Bonds.)

Good Growth Locales

Some of the fastest growing cities are Dallas and Austin, Texas; Cape Coral, Destin and The Villages, Fla.; St. George, Utah and Myrtle Beach, S.C. That said, you should do your own research to see if there have been any recent changes. Also remember that you can invest in county and/or state municipal bonds as well. For a higher likelihood of tax advantages, invest in your local area.

Two other important notes: Housing and hospitals/healthcare have been the two sectors with the highest default rates in recent years. Secondly, several states have legislation designed to help local governments. These states include New York, Michigan, Pennsylvania and Rhode Island (though this didn’t do much for Detroit).

If you don’t want to deal with the process of investing in individual municipal bonds and you desire liquidity, then you might want to look into municipal bond ETFs. Here is a list.

All numbers as of October 8, 2015.

iShares National AMT-Free Muni Bond (MUB)

Tracks

S&P National AMT-Free Municipal Bond Index

Net Assets

$5.5 billion

1-Year Performance

-0.83%

3-Month Performance

0.72%

Dividend Yield

2.58%

Expense Ratio

0.25%

Average Daily Trading Volume

285,213

 

Bond Ratings for MUB: (For related reading, see: How Are Municipal Bonds Taxed?)

AAA

21.22%

AA

57.57%

BBB

19.91%

BB

1.27%

B

0.04%

 

SPDR Nuveen Barclays ST Muni Bd ETF (SHM)

Tracks

Short-Term Tax-Exempt Municipal Bond Market

Net Assets

$2.63 billion

1-Year Performance

-0.12%

3-Month Performance

0.25%

Dividend Yield

0.91%

Expense Ratio

0.20%

Average Daily Trading Volume

572,640

 

Bond Ratings for SHM:

AAA

24.62%

AA

75.04%

A

0.29%

 

SPDR Nuveen Barclays Municipal Bond ETF (TFI)

Tracks

Barclays Municipal Managed Money Index

Net Assets

$1.49 billion

1-Year Performance

-0.5%

3-Month Performance

1.26%

Dividend Yield

2.34%

Expense Ratio

0.23%

Average Daily Trading Volume

407,484

 

Bond Ratings for TFI:

AAA

15.33%

AA

83.84%

A

0.77%

BBB

0.03%

 

Market Vectors Intermediate Muni ETF (ITM)

Tracks

Barclays AMT-Free Intermediate Continuous Municipal Index

Net Assets

$1.18 billion

1-Year Performance

-0.42%

3-Month Performance

1.42%

Dividend Yield

2.35%

Expense Ratio

0.24%

Average Daily Trading Volume

250,070

 

Bond Ratings for ITM: (For related reading, see: 4 Top Municipal Bond ETFs.)

AAA

15.24%

AA

60.17%

A

22.02%

BBB

2.42%

BB

0.02%

 

iShares ST National AMTFree Muni Bnd (SUB)

Tracks

S&P Short Term National AMT-Free Municipal Bond Index

Net Assets

$895.68 million

1-Year Performance

-0.31%

3-Month Performance

0.09%

Dividend Yield

0.76%

Expense Ratio

0.25%

Average Daily Trading Volume

46,972

 

Bond Ratings for SUB:

AAA

35.94%

AA

49.70%

A

13.85%

BBB

0.52%

 

PowerShares National AMT-Free MuniBd ETF (PZA)

Tracks

BofA Merrill Lynch National Long-Term Core Plus Municipal Securities Index

Net Assets

$884.8 million  

1-Year Performance

-1.26%

3-Month Performance

1.13%

Dividend Yield

3.71%

Expense Ratio

0.28%

Average Daily Trading Volume

151,582

 

Bond Ratings for PZA:

AAA

6.32%

AA

86.24%

A

7.12%

BBB

0.32%

The Bottom Line

Don’t be fooled by just looking at 12-month performance and dividend yield. SHM isn’t the top option in either category, but it’s the most liquid, the most resilient, it has the lowest expense ratio, and it comes with the highest bond ratings, which relates to it being the most resilient. If you’re going to invest in a municipal bond ETF, then you might want to begin with SHM. If you’re going to invest in an individual municipal bond, then apply logic to every situation and you should do fine. Municipal bonds are a good addition to a diversified portfolio as long as you choose correctly based on population and local economic trends. As always, do your own research prior to making any investment decisions. (For more, see: 20 Investments: Municipal Bonds.)

Dan Moskowitz does not have any positions in MUB, SHM, TFI, ITM, SUB or PZA. He is currently long DUST and EDZ. He indirectly owns TLT, EUM, SJB, AWR and RAI. 

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