Is now the time to buy muni bonds?

Worries about out-of-control state deficits, underfunded municipal pension plans and rising interest rates have been kicking the teeth out of the municipal bond market lately, with prices plunging and yields soaring.

And that’s got some contrarians saying that now may be the time to jump into the market.

“This is a great time to get into munis for anyone looking for income in their portfolio,” said Mark R. DeMitry, senior portfolio manager at the Oppenheimer Funds. “If you have a long-term horizon and can withstand the ups and downs of the market, it seems like there’s a great opportunity.”

To be sure, people getting into munis today — particularly those buying the bonds of economically troubled states, such as California — must be both intrepid and careful. The market is exceptionally volatile, buffeted by credit concerns, interest rate worries and swings in supply.

Still, for those in high tax brackets, it’s hard to beat the returns. California’s 30-year general obligation bonds were yielding 6% — tax-free — last week, DeMitry said. For a California resident in the highest tax brackets, that’s the equivalent of earning 10.21% on a taxable investment.

So should you consider buying municipal bonds? If so, what are the risks and how can you minimize them?

• Who should buy?

Municipal bonds are best suited to people in the highest federal and state tax brackets. That’s because the interest earned on the bonds is exempt from federal taxation and, if you’re buying bonds issued by the state in which you live, they’re also exempt from state tax. The higher your tax bracket, the more valuable those exemptions can be.

A 6% return is worth 10.21% to somebody paying 35% of their income in federal tax and 9.55% to the state, but it’s worth only about 8% to someone in the 25% federal tax bracket who pays little or no state income tax. (Morgan Stanley offers a simple “taxable equivalent yield” calculator on its website for those who want a rough estimation of the equivalent yield on any given bond.)

But you don’t get yields like these without taking some substantial risks.

• Default risk

For small issues and some types of so-called revenue bonds, the biggest risk is default. While few experts expect general obligation bonds — those backed by the full credit of the state or municipality issuing them — to stop making payments to investors, bonds that were issued to finance stadiums and commercial developments look shaky, said Marilyn Cohen, president of Envision Capital Management in Los Angeles. That’s because repayment is usually tied to the economic health of a project, and many of them are not doing as well as expected.

On the other hand, general obligation bonds, which usually finance utility projects, airports and the like, are generally on solid ground, she said.

“You have to know what you’re investing in,” Cohen said. “Look for bonds that finance necessities.”

• Interest rate risk

Another significant concern for bond holders is whether interest rates are on their way up. If interest rates rise, the value of existing bonds issued at relatively lower yields will fall. The best way to address that risk, Cohen said, is to keep durations relatively short.

She said she’s buying only those bonds that repay investors in 10 years or less.

Though shorter-duration bonds’ value will fall too if interest rates rise, they aren’t likely to fall as far.

• Flight risk

When you invest in munis through mutual funds, you also need to be worried about whether other investors will get spooked and flee. If they do, your bond fund manager will have to sell bonds, locking in losses, to raise the cash to pay off those investors.

If you’re investing for long-term income, you might be better off buying individual bonds, Cohen said. That way the only emotional responses you need to worry about are your own.

• Tax wild card

Because municipal bonds are sold based on their taxable equivalent yield, what happens to the U.S. tax system is incredibly important to muni investors. With record federal budget deficits, many investors are expecting some sort of change to the tax code. But there’s no consensus about what it might be.

One camp believes the government could raise taxes, which would make municipal bonds more valuable. The other thinks the government might follow the direction of President Obama’s deficit reduction panel, which recently recommended cutting tax rates and doing away with most deductions, credits and exemptions, such as the income tax exemption for municipal bond interest. That would savage muni values.

Barring psychic revelation, muni investors can only ask themselves the “Dirty Harry” question: “Do you feel lucky?”

business@latimes.com