An official with the Securities and Exchange Commission — an agency not given to hyperbolic statements — said this $3.7 trillion market is facing an “Armageddon.” 

In June alone, $5.4 billion flooded out of this market — more than was invested in all of 2012. Rising interest rates will likely depress the value of this market over the next few years. Not only that, but President Barack Obama wants some investors in this market to face an unprecedented penalty.

Why should you give it even a cursory glance?

In 2012, this market finished a two-year run with an average 20% gain, according to Bank of America Merrill Lynch. It is one of the most trustworthy places to put your money, especially if you’re a retiree.#-ad_banner-#

I’m talking about U.S. municipal bonds.

Municipal bonds are issued by non-federal governmental entities to build roads, schools, hospitals and the like. In 2012, 6,600 tax-exempt municipal bonds financed more than $179 billion worth of infrastructure projects, according to National Association of Counties.

Nearly three-quarters of these bonds are held by individual investors, according to the SEC.

With about 50,000 local bond issuers across the country and more than 1.5 million bonds outstanding, no two municipal bonds are exactly alike. Yet right now they’re all being tarred with the same brush.

Here are three key reasons they’re in the headlines.

	The Federal Reserve signaled that it might begin easing off its bond purchases in a “tapering” of its quantitative easing program later this year. After the Fed‘s signal, investors dumped anything with the word “bond” in it. That selling drove up the yield on the benchmark 10-year Treasury from 1.63% in early May to a recent 2.74%. That, in turn, has pushed up long-term rates on municipal bonds.
	The City of Detroit defaulted on two bond payments before declaring bankruptcy this week. The defaults were a pretty minor event for individual investors because those specific bonds were insured. As for the bankruptcy, Detroit will negotiate repayment terms that will delay repayment for some for the highest-rated bonds, will hit the insurers, not the bond holders or the individual funds. Detroit’s plan for getting its finances in order calls for bondholders to shoulder some of the burden. The possibility of that turn of events is what had SEC Commissioner Dan Gallagher invoking the end of the world. He was not saying that municipal bonds have become bad investments — he was referring to the change in how different bond classes are handled in restructurings could make it more difficult and expensive (because of higher insurance rates) for municipalities to issue bonds in the future. And he was right. Hundreds of millions of planned municipal bond issues have been canceled or postponed.
	For the first time, the U.S. Treasury said it would support the measure to tax higher-income investors who hold tax-free bonds to help close the budget gap.

Some Comforting Facts
As far as the individual investor is concerned, none of the fundamentals of municipal bond investing has changed. This market is still one of the most trustworthy places to put your money.

Municipal defaults are rare. According to Moody’s, there was an average of 4.6 a year from 2008 through 2012. Although that is up from an average of 1.3 per year from 1970 to 2007, in a universe of 1.5 million bonds outstanding, it’s minuscule.

	The City of Detroit defaulted on two bond payments before declaring bankruptcy this week.

As for defaults this year, Merrill Lynch expects that $573.2 million worth of municipal bonds will not meet their obligations. In context, that is 0.6% of the $3.7 trillion of municipal bonds outstanding, compared with 1.01% for all of last year.

Municipal bonds offer higher income than investment banking. For example, an AAA-rated tax-free bond maturing in 10 years yields 2%. For an investor in the 35% federal tax bracket, that’s equivalent to 3% from a taxable bond. Not bad when you’re lucky to get 1% from a CD.

A key benefit of municipal bonds: The steady income stream doesn’t fluctuate with the “value” of the bond in the resale market. And, if you hold an individual bond to maturity, you get back the face value if the issuer can make good. Rising interest rates will not affect you. 

Types Of Muni Bond Risks
Credit risk: Even with Detroit’s defaults and bankruptcy, default remains extremely rare. However, you can further insulate yourself from credit risk by concentrating on two things: The type of bond and its credit rating. 

The safest type of municipal bond is the general obligation bond, which is paid back with tax revenue the municipality collects. General obligation bonds in general have the lowest default rate. According to Moody’s, only five general obligation defaults have occurred in the past 41 years, and no state has defaulted since 1933.

Conversely, investors should generally avoid revenue bonds, which are paid back by a project’s fees. 

Source: FMS Bonds

Investors should consider municipals with the highest credit rating, AAA. Credit ratings are no guarantee, but no credit rating is a red flag. Part of what helps bonds achieve an AAA rating is that they are insured, which will help make investors whole in the event of a default. 

Fund investors should stick to funds that hold securities rated A to AAA. Consider Vanguard Intermediate-Term Tax-Exempt Fund (MUTF: VWITX), as its duration is about five years. Moreover, 95% of its portfolio is rated A or better. 

Interest rate risk: Rising interest rates only affect the value of municipal bonds selling in the market. The cash flow (income) remains unaffected. Furthermore, interest-rate risk increases the longer a bond is held. 

Note that risk can be extreme. A 1-point rise in the interest rate could cut 10% of a municipal bond’s value with a long duration. 

Consider bonds with relatively short-term maturities if you need to cash out. For example, if market rates rise, a bond maturing in two years will decline less than a bond maturing in five years. However, by owning shorter-term bonds, you’ll earn less interest income, so you’re trading yield for less volatility.

Fund owners should know their fund‘s duration. This is also a good time to snap up bargains. Consider Vanguard Limited Term Tax Exempt Fund (USMF: VMLUX). 

Call Risk: The call option has a huge impact on why municipal bonds are so interest rate-sensitive. Call risk is primarily an issue if you don’t want to receive your principal early and are counting on the cash flow. Note that bond calls are less likely when interest rates are stable or moving higher. 

Research a bond’s call provisions if you’re purchasing to secure steady income. A typical 10- to 12-year muni bond will have a 5% coupon, which means it will almost certainly be called within three to four years. That is, as soon as the issuer can refinance the bonds. 

Tax Risk: For the past 100 years, there has been a federal tax exemption for purchasers of municipal bonds. If a new tax on tax-free bonds is passed, this will obviously make municipal bonds less appealing. Many investors have been willing to accept lower interest rates because of the exemption. Mitigating this risk may mean a complete overhaul of your financial portfolio.

Action to Take –> With the municipal bond market undergoing changes — even if it’s not an Armageddon — there is a silver lining for committed buyers. Any increase in rates will ultimately pare back new issues, supporting prices and allowing investors to build income streams with higher coupons. Bonds are not immune to risks, but investors can continue using them as a conservative tool for steady income and (for now) a tax-efficient portfolio.

P.S. — Does Detroit’s bankruptcy have you thinking the market is ripe for a pullback? An eccentric Texas woman who dodged the 2008 financial collapse would agree. This is the same analyst who’s produced annual returns of up to 510%, and has picked winning investments roughly 85% of the time. To learn how she’s protecting her portfolio today, click here.