Municipal bonds are still boring, and still (mostly) safe

— -- Q: Are municipal bonds still safe?

A: During large-scale financial panics, as we've witnessed this year, investors learn the definition of risk.

As the credit markets constricted, investors pulled their money from any financial institution or lender they perceived to have even the tiniest amount of risk of default.

The most nervous investors then flocked to the safest securities they could find: debt issued by the U.S. government that matures in three months or less. That flight to short-term Treasuries is a reminder that they remain popular among investors looking for safety.

The panic affected areas of the bond market that are normally considered tremendously safe. Investors sold corporate bonds of many companies, including large companies with the highest credit ratings. And they sold debt issued by cities, states and other municipalities.

The result has been historic. Investors have sold municipal bonds to such a degree that the Bond Buyer's 20 bond index, which tracks municipal bonds, was yielding 5.36% in early October. That was up from 4.62% a month ago and higher than equivalent Treasury yields.

Generally, municipal bonds have yields below Treasuries because the income from munis is tax-exempt. The fact yields are so elevated shows just how nervous investors are.

Let's be clear. If safety is your top concern you should put your money in an FDIC insured bank or short-term Treasury bills. If you can handle more risk, municipal bonds are considered safe because cities and states have taxing authority. Local governments can raise taxes and fees to pay back their debts. What's more, muni bond issuers have traditionally carried insurance that would pay lenders in case of a default.

But now, the insurers are in poor financial health due to the credit crunch. In addition, investors are worried about the financial hit many cities and states will take because of the state of the economy. As a result, investors have been reluctant to buy munis, says Monte Avery, portfolio manager of Integrity Mutual Funds.