Muni bond downgrades add risk - but potential for higher returns, too

Matt Fabian, of Municipal Market Advisors in Concord, says yes. Interest rates on California’s tax-free bonds have jumped. Residents can get yields of 6.2 percent on long-term bonds. Nonresidents will find the bonds in many national municipal funds.

Warren Pierson, at Baird Intermediate Municipal Bond Fund in Milwaukee, at the moment says no to the fiscally weakest state. California’s credit rating could drop to BBB from A today, he says, raising yields even further. “We would then most likely get involved.’’

The California mess confronts the question of what it means to be an income investor. Ten-year AA-rated general obligation bonds, backed by the issuer’s taxing power, are yielding an average of 4 percent, down from 5 percent six months ago. To get 5 percent today, investors generally need A-rated bonds or lower.

At lower-quality levels you face more risk. Owning a portfolio of funds is safer than gambling on just a few issues.

Defaults on munis rose to record levels last year and might easily rise again. Even so, they’re relatively rare. Downgrades are more common, and that’s what you have to worry about, says Baird’s chief investment officer, Mary Ellen Stanek. When a credit rating firm cuts an A-rated bond to A-minus or BBB, its market price plunges. The downgraded bond continues to pay its fixed rate of interest, but if you have to sell it, you’ll take a loss.

Standard & Poor’s Ratings Services downgraded 327 municipal issues in the first quarter alone, already exceeding the total of 264 for all of 2008.

And who believes ratings firms are up-to-date? Municipalities aren’t bound by the same financial disclosure rules as corporations, and are notoriously poor at revealing negative information.

What’s your priority? If income is primary, look for a mutual fund that buys at least some lower-rated issues, Fabian says. Consider quality funds that tip toward the lower end of the investment-grade range - bonds rated A and BBB. They provide slightly higher income at less risk than you’d get in a high-yield fund.

He also suggests that you allocate 20 percent of your bond money to high-yield funds. You have to be able to live with their volatility. In a poorer market, they could drop 20 percent or more.

Quality bond funds are the right choice for people who want liquidity as well as income. Pierson favors intermediate-term over long-term bonds. They give you the lion’s share of the value while reducing the risk. To juice the income a bit, he looks for downgraded bonds that are still good credits.

Buying individual bonds is always a question. Retail investors pay more than institutions do and take a haircut in price if they have to sell before maturity.

Jane Bryant Quinn is a Bloomberg News columnist.