Just how safe are long-term municipal bonds?

When a city needs to construct a new school, improve a park or build a stretch of highway, they usually borrow money, but not from a bank. The money used to fund these projects comes from investors like you.

Investors who purchase municipal bonds issued by a state, city or county essentially loan money for a specific project -- and sometimes for day-to-day operations -- with the understanding that their capital will be protected and returned when the bond matures. As they wait for this to happen, these investors will be able to receive tax-free income from interest or reinvest their earnings. Every investment comes with some risk, but long-term municipal bonds are one of the safest investments you can make [sources: Investopedia, Securities and Exchange Commission].

Before you run down to city hall with cash in hand, it helps to understand the process. Your investment doesn't need to be tied to your locale. Instead, you work with a broker, who can help you identify and purchase long-term municipal bonds. You could, for example, help fund a bridge-building project several states from where you live. In fact, the people who propose the bond project will probably never know your involvement because your investment will be one of thousands rolled into a bond fund.

You'll also want to know the difference between the two most common types of municipal bonds:

General obligation bonds: When a municipality issues a general obligation bond, it intends to repay the debt through a variety of sources, from taxes to revenue-generating projects. Although the municipality doesn't need to put up any assets as collateral, these bonds generally carry a low risk of default because they are backed by the "full faith and credit" of the municipality. This means the municipality promises to pay back the bond and, according to the strength of the municipality's credit rating, probably will -- especially since they can raise taxes to do so [source: Investopedia].

Revenue bonds: When a municipality issues a revenue bond it is usually to finance an income-producing project, such as a local sports stadium or toll road. The debt is repaid with revenue from the project funded by the bond, a maturation process that can take 20 to 30 years. The income from the project itself is used as collateral, after expenses have been paid. Revenue bonds carry a higher risk of default because they rely on the success of the project they fund [source: Investopedia]. Operational expenses are paid first from the revenue generated, and then bondholders get paid.

What makes a municipal bond a safe investment?

In its bid to change from its agricultural roots and reinvent itself as a tony tourist destination, Stockton, Calif. issued several municipal bonds. The city incurred the debt to finance buildings like a marina and a stadium, expecting a payoff from its gamble. But it was not to be. Crashing real estate prices (which severely lowered income from property taxes) and high pension benefits for retired city workers greatly strained finances.

In 2012, Stockton filed for bankruptcy. It became the biggest city in U.S. history to default on its debts, a move that caused a ripple of concern among those who'd long believed city government bonds were a failsafe investment [source: Kristof].

Stockton isn't alone. Between 2010 and 2012, 31 local governments and city authorities (such as improvement districts) have declared bankruptcy. And that's only in the 22 states that allow municipalities to seek bankruptcy protection [source: Governing]. Despite the rash of defaults, they're still relatively rare -- about 0.3 percent annually [source: Kristof].

If you're planning to invest in municipal bonds, it pays to do some research. Here are some key details:

Check the record: Does the municipality have a history of paying on time? It's surprisingly easy to find out. Visit the Municipal Securities Rulemaking Board's Electronic Municipal Market Access portal.

Check the credit rating: What is the bond's credit rating? Look for bonds rated BBB or better by Standard & Poor or Fitch, or rated Baa or better by Moody. Even better, look for those that earn the highest rating from Moody (Aaa), Standard & Poor (AAA) or Fitch (AAA).

Check the call risk: A "call" means a bond can be redeemed (paid off) whenever the issuer decides, even if it hasn't reached maturity. This often happens when interest rates fall because it can save the issuer money. For investors, this means you run the risk of lost money, either in interest payments or capital. Most bonds, however, are non-callable [source: The Securities Industry and Financial Markets Association].

Lots More Information

Author's Note: Just how safe are long-term municipal bonds?

I learned something surprising while researching this article, and that's how interesting municipal bonds can be. A new school under construction, a bridge being built, a state-of-the-art water treatment plant -- all of these things are happening around my community. And all are probably financed, at least in part, by municipal bonds. The idea of being able to make something possible, if only by being one of many individual lenders who buy into a bond, is one that appeals to me -- even if the project doesn't take place in my own backyard.

Sources

Governing. "Bankrupt Cities, Municipalities List and Map." (Feb. 16, 2013) http://www.governing.com/gov-data/municipal-cities-counties-bankruptcies-and-defaults.html
Investopedia. "General Obligation Bond." (Feb. 16, 2013) http://www.investopedia.com/terms/g/generalobligationbond.asp
Investopedia. "Revenue Bond." (Feb. 16, 2013) http://www.investopedia.com/terms/r/revenuebond.asp
Investopedia. "The Basics of Municipal Bonds." Aug. 5, 2012. (Feb. 16, 2013) http://www.investopedia.com/articles/bonds/05/022805.asp
Kristof, Kathy. "Are Municipal Bonds Still Safe Investments?" Kiplinger. October 2012. (Feb. 16, 2013) http://www.kiplinger.com/article/investing/T052-C000-S002-are-municipal-bonds-still-safe-investments.html
Kristof, Kathy. "How to Buy Muni Bonds Safely." Kiplinger. October 2012. (Feb. 16, 2013) http://www.kiplinger.com/article/investing/T052-C000-S002-how-to-buy-muni-bonds-safely.html
Securities and Exchange Commission. "Municipal Bonds." (Feb. 15, 2013) http://www.sec.gov/answers/bondmun.htm
The Securities Industry and Financial Markets Association. "How Safe Are Municipal Bonds?" (Feb. 16, 2013) http://www.investinginbonds.com/learnmore.asp?catid=8&subcatid=53&id=235