Municipal bonds are worth a look if you can handle the risk

— -- Q: How do I go about adding municipal bonds to my portfolio?

A: Lending money to cities, states and local government agencies used to be a good move for investors in high tax brackets. That's made municipal bonds attractive investments for years.

By buying municipal bonds, investors looking for income not only received regular payments, they got excellent tax savings. The income paid by municipal bonds is typically exempt from federal taxes and often exempt from state taxes, if the investor lives in the state issuing the debt.

The whole muni bond market suffered a body slam during the credit crunch. Now, investors have become increasingly concerned about the ability of states and local governments to pay their debts.

This wasn't much of a concern before, since most local governments offered investors insurance to cover the possibility of default. But many bond insurers have been crippled by mortgages losses, so the value of the insurance has diminished.

The result? Yields on municipal bonds are attractive, but only if you can handle the higher risk. Gone are the days when you could blindly buy a municipal bond and assume even if things went badly you could get your money back.

That's an astounding yield if you consider the after-tax yield for a person in the 25% tax bracket is closer to 4.5%. It's even more impressive if you consider that the yield on 10-year Treasuries is just 3.0%.

Does this mean you should consider muni bonds? Clearly, if you understand the risks it's hard to argue with the yields. Just remember, though, that you can't just blindly buy single muni bonds anymore. If you're buying individual bonds you must take the time to understand the municipalities' demographics, tax trends and fiscal position.