BOSTON (TheStreet) -- The so-called "bond bubble" still hasn't burst as some predicted. Even the creeping strength of equity markets hasn't been enough to shake investors from a seemingly safe fixed-income play.Despite some tremors in the municipal bond market -- Harrisburg, Pa., needed an advance in state aid to avoid default on a $3.3 million bond payment last month, for example, and in August the Securities and Exchange Commission charged the state of New Jersey with making misrepresentations on more than $26 billion in bonds sold from 2001 to 2007 -- savvy advisers have been insisting for more than a year: Munis are where it's at. Investors have taken a lot of convincing. "You hear a lot of investors very concerned about munis," David MacEwen, fixed-income chief investment officer at American Century Investments, told a TheStreet.com, "but municipalities will cut their budgets or sell their assets and do whatever it takes to balance their budgets." That said, in considering the municipal bond marketplace as part of such a strategy, investors can find opportunity and peril. Keep in mind seven points and perils dwindle to manageable size while opportunities loom large: DON'T GO IT ALONE
Tom Collimore, director of investor education with the CFA Institute, says the current muni marketplace is a mix of fundamentally safe and high-risk issues. "On the risky side of things, you have dirt bonds that are unrated or junk-bond rated, where you have not only a lot of risk and a real dire need for analysis," he says. "Especially at the unrated or junk-rated end of things, I think it is hopeless to think that the individual investor can do it
In addition to seeking professional guidance, investors also want to make sure they are diversified with their holdings. "You can't have everything in just a handful of bonds," Collimore says. "You want to be in a diversified fund. For the average retail investor, you want to be in a mutual fund. For the average high net worth person, you could be in a separate account somewhere that is managed professionally." "It is not an all or nothing proposition," he adds. "There is no reason for most people to be thinking about putting all their money into munis and they may be exposing themselves to exposure risks they are not comfortable with. There's no reason why people shouldn't have some money in muni bonds, but don't go crazy."
Many investors gravitate to municipal bonds for the wrong reason, often over-relying on their role as a tax-advantaged investment, Collimore says. Inflation, he says, can be a more important consideration. "People should consider muni bonds as an asset class subject to inflation as any other fixed-income security is," he says. "Inflation is tax. People get hung up on the dollar amount they write on that check to the IRS, but the reality is that if inflation comes roaring back at a 5% or 10% inflation, it is the same as a tax ... maybe people would be more alert to that risk if they thought of it that way." The popularity of taxable Build America Bonds, with more than $150 billion issued in the past 18 months, can make sense in this respect, Collimore says. "As a taxable matter, you are getting muni exposure without getting the muni tax benefit, and that may be all right," he says. "If you are not in a particularly onerous tax situation, you shouldn't assume that you should be in tax-advantaged investments. You might be better off paying the taxes." "There are people who just have this instinctive reaction to seeing a tax bill, and it doesn't apply to inflation or loss of income," he adds. "It is just that the check they write to the IRS bothers them, and that can be irrational." DON'T RELY ON RATINGS
Regina Shafer manages the USAA Tax-Exempt Intermediate-Term Fund ( USATX - Get Report), which recently moved to a five-star fund rating on Morningstar ( MORN - Get Report). Last year, her fund had an 18.28% return, ranking it first out of 157 funds in its Lipper category. She credits much of that success to a team of municipal analysts that review every security she buys. "We continually review all the holdings in our portfolio,"she says. "I think that's really paid off in this environment. We've never really just relied on the bond insurers, or on the ratings agencies. Over time it has really paid off and allowed us to look beyond the headlines, find some value out there and not just rely on somebody else to tell us what a good credit or a bad credit is." IT IS MORE THAN JUST FINANCIALS
"We start with the financials, but it is not just about that," Shafer says. "It is also politics and the importance of the projects we are looking at." She cites hospital bonds as an example of how understanding the marketplace pays off. "We look at the financials, but we also look at where the hospitals are located," she says. "We don't necessarily select the hospitals that are in urban areas where there is a lot of competition. We like rural hospitals that are the top provider in the area. We feel like even if there are political changes or funding changes, that hospital is going to survive."
Shafer cites California as a state whose financial woes may be unnecessarily scaring away investors. "Even with their slowdown, they are still the eighth-largest economy in the world," she says. "They are not going to not pay their debt. Debt service for them is the second-highest priority, right after education. Debt service is not a very large percentage of their budget and they know the importance of access to the markets. They are not going out of business just because they are having a bad year." "There are four or five municipalities that are really having trouble right now, but there are over 18,000 cities out there," she says. "Security selection and understanding what you are buying can really make a difference." THERE ARE FEWER PROTECTIONS
"The market is not as investor-friendly as it used to be," Shafer says. "A few years ago, over 50% of the market was insured with AAA municipal bond insurance, which made it easier to have a diversified portfolio of securities that you could feel comfortable with. Because we manage a mutual fund, we never relied too much on bond insurance. We always looked to the underlying credit. Now you have to do that. There is now essentially one bond issuer who is insuring about less than 10% of the market." -- Written by Joe Mont in Boston. >To contact the writer of this article, click here: Joe Mont. >To follow the writer on Twitter, go to http://twitter.com/josephmont. >To submit a news tip, send an email to: firstname.lastname@example.org.