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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Ask The Expert: Are Municipal Bonds Really Safe?

Question: Should I consider municipal bonds safe? 

-- Tara, Seattle, Washington

The Investing Answer: The recent bankruptcy of Detroit has caused a large number of people to ask that question. 

How are they answering it? By putting their money elsewhere. According to Lipper, more than $20 billion was withdrawn from U.S. municipal bond mutual funds in the second quarter of 2013. (That was before the Motor City officially filed for bankruptcy in July, but Detroit's woes -- and those of other struggling cities around America -- were well-known long before that.)

But what is the real answer? Are these bonds safe?

The short answer: "No, not completely." 

Why? Because no investments are truly safe other than savings accounts or checking accounts that earn interest. 

But that doesn't mean you should stick all your money in your mattress or the bank equivalent -- savings accounts. At present rates, you'd earn less than a 1% return on your deposits. Not exactly the fast track to retirement.

Municipal bonds are bonds issued by local governments to pay for public goods such as roads, bridges and public-use buildings. You have to look at how cities earn their money just like you would look at corporate financials before buying a corporate bond. It is possible if the city can't gather the funds you lent them back, you won't get repaid. That's got bondholders in Detroit feeling a little edgy these days.

Revenue that repays municipal bonds can come from the city budget or from tax initiatives. It's important for you to know how and when your bond is repaid. 

Certified financial planner Leslie Beck recommends using common sense when picking municipal bonds. For example, she says she would buy airport bonds for Los Angeles and San Francisco international airports but not for Reid-Hillview Airport in San Jose, California. "I think Reid is well-run and looks very busy, but it is not an 'essential' airport. It could be closed," she says. "If you never heard of the community, do not buy it. I can spend the time researching the community or the issuer, but most individuals should just move on."

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"If the bond is to provide water and sewer facilities for a wealthy community or a large city, you can make a good assumption that somehow the community will allow itself to be taxed in order to have the essential service," Beck says. "Most schools would also apply -- but make sure it is for a solid school district, not one that is losing a lot of people, as in some rural areas."

But it isn't just rural areas that could be struggling, as Detroit proved. That means doing your homework is all the more important.

Information on city economics is easy to research. You can find out necessary information by contacting city government departments or reading your local paper. I always search the online archives for any topic I'm interested in reading about. For instance, if a school district is losing huge numbers of students to nearby districts or private schools, you can easily find out.

When it comes to earning the stated amount of interest, keeping your bond until maturity (the full term of the loan, such as 10 or 30 years) is the best way to guarantee you will earn the money you expected, says Beck. She warns, though, that it may not be the best idea to invest your entire life savings in municipal bonds. The low interest rates currently offered can jeopardize long-term financial goals if you avoid all other long-term investments. "Don't lock up all your money for 30 years at 3%, like some people did last year, just to get a decent return."

Municipal bonds are a relatively safe investment. Beck keeps municipal bonds in her own portfolio. Over the course of the next five years -- potentially even in the next year -- interest rates will rise above 2008 levels, Beck says. The increased rate earned will be great for new bond holders. However, it could drop the value of old bonds with lower interest rates. Primarily when this matters is if the bond is sold before the bond reaches its maturity date.

Bottom line: Buy only bonds that you will hold until maturity, but don't forget to do your research. You don't want to try to sell your bonds earning low interest rates when interest rates increase. Who would want to be guaranteed low interest rates when higher rates are offered again?

Don't buy municipal bonds blindly. Government projects can lose money. Don't let them lose yours.