Good Question. First the dot-com bubble burst. Then housing. Could municipal bonds be next? Some think so.

Here are their reasons:

1.    Huge demand for bonds in last two years. Roughly $500 billion was invested in bonds and bond funds in the last two years, just about the same amount that went into equities in 1999 and 2000, right before the tech bubble burst.

2.    Recent Sell-off. A sell-off in bonds has lifted the yield on 10-year treasuries by over one percentage point since November 4; the day QE2 was announced. 

3.    Increased Risk of Default by State and Local Governments. Concerns over the European debt crisis have now spread to some troubled U.S. states and municipal bond markets. The New York Times reported that Illinois, California and several other states are at increasing risk of being the first states to default since the 1930s. 

4.    The Build America Bond Program is ending December 31, 2010. This program provided a federal subsidy of 35% of the interest on newly issued taxable infrastructure bonds. BAB issuance accounted for about a quarter of the muni sales in 2010. Without the program, the supply of munis will expand by about that much in 2011, which naturally will drive down prices.

5.    Budget and inflation concerns. In simple terms, "quantitative easing" is writing checks. The Fed hopes these will re-inflate capital markets and reduce unemployment rates. While QE2 may have some short-term temporary benefits, in the long run, QE2 will contribute to inflation. Furthermore, it seems unlikely that the US will grow its way out of its national debt.

6.    Push into equities. Rising inflation fears and growing of a "bond bubble" is causing many investors to return to the stock market. Continued strong earnings and stock market advances are restoring investor confidence.

So, Why Hold Municipals at All?

1.    Hi-quality, short-to-intermediate term munis continue to have an important place in the portfolios of investors who need fixed income and are in high marginal tax brackets.

2.    Tax-equivalent yields are still attractive. A 3.5% yield on a municipal bond is equivalent to a 5% yield on a taxable investment to an investor in the 30% marginal tax bracket. 

3.    The historical default rate for investment grade municipal bonds is near zero over the last forty years, substantially less than corporate bonds.

4.    Demand for munis should stay strong due to the two equity bear markets in the last decade and an aging population which needs more fixed income.

5.    No one knows the future of the economy or interest rates. While inflation seems inevitable down the road, the next few years might go one of three ways. First, the economy could crumble and interest rates could fall. Second, the economy could muddle along and interest rates stay about where they are. Or, three, the economy and inflation could take off. Holding municipal bonds would be advantageous in scenarios one and two and with proper management could still provide a decent return in scenario three.

The Key is Management.

1.    Be Selective. Only invest in investment grade munis. Ratings change and the quality of the munis must be regularly reviewed.

2.    Diversify. Municipal bond funds and ETFs are a great way to diversify. If you hold individual bonds, you'll want at least 16-20 individual bonds for your bond ladder. These should be diversified by type (General Obligation and Revenue), sector, maturity, and geography.

3.    Manage Duration. This is the "adjusted time to maturity" of the bond. We generally advise keeping the average duration on bond holdings to less than five years.

4.    Utilize Bond Ladders. Because maturities are staggered, bonds are maturing regularly and, at that time, returned principal can be invested at prevailing market yield rates.

5.    Put in Context of Your Overall Asset Allocation. Consider other bond holdings in addition to munis. It may be appropriate to consider international and emerging debt as well as high-yield bonds for a portion of your fixed allocation. Dividend paying stocks or ETFs may also be appropriate.

6.    Active Management. Municipal bonds have changed. They are not the "boring", risk-free investment your grandfather held. The focus then was being able to buy a muni with a great yield, perhaps with a long maturity. These days, investors need a strategy and then continual monitoring and adjustment to given conditions to steer clear of land mines and capitalize on short-term and long-term opportunities. You need both the right purchase and the right active management.