With income tax rates scheduled to rise next year, tax-exempt income is becoming more desirable. Moreover, any investment income at all is desirable in these days of zero-based bank accounts and money market funds.

So it's not surprising that investors have poured billions of dollars into municipal bonds and municipal bond funds. Morningstar reports that municipal bond funds had inflows of $72 billion in 2009 and another $15 billion in the first four months of 2010-16 months in which U.S. stock funds had net outflows of nearly $20 billion.

And these investors have been rewarded handsomely for their interest, according to Morningstar. While municipal bond funds lost an average of 7.6% during the downturn in 2008, they gained 15.8% on average in 2009. Through the first five months of 2010, municipal bond funds were up 2.7%.

While earning 3% or 4%, tax-exempt, may seem appealing, caution is advisable. Many booms have been busted in recent years, and tax-exempt bonds might not be bust-exempt.

What could go wrong in the muni market? There are many possibilities. Spreads could widen, interest rates could increase or an upgrade in bond ratings could leave investors paying more for their munis. Bigger picture, credit risk and default could be more serious issues, driven by controversial long-term pension obligations.

THREE STRIKES

Three dangers could affect municipal bonds: spread risk, interest rate risk and rating risk.

Spread risk. Some potential hazards could affect any type of bond that has enjoyed recent popularity. "Inflows have been heavy because investor demand for municipal bonds has been strong," says Josh Gonze, managing director of Thornburg Investment Management and co-portfolio manager for Thornburg municipal bond funds in Sante Fe, N.M. "Therefore, prices are relatively high now, and yields are low."

In early 2009, at the peak of the financial crisis, there was a huge gap in yields between AAA-rated munis and lower-rated bonds, Gonze notes. Investors were rewarded for taking some credit risk.

Since then, spreads have tightened and the yield gap has narrowed, with prices rising and yields falling on lower-rated munis. If spreads widen in the future, market prices of many munis will fall, particularly lower-rated ones. "Values will look dismal on clients' statements," Gonze says.

Interest rate risk. Munis are also vulnerable to interest rate risk; as is the case with most bonds, higher interest rates will lower values.

At some point, the economy will creep up, inflation will creep up and interest rates will rise from current low levels, says Bill Veronda, municipal bond analyst at Carolina Capital Markets in Chapel Hill, N.C. "It might take a year or two, but the next big move probably will be higher. Except for very short-term issues, all bonds may lose some value."

One approach is to stay short-term in fixed-income holdings, including munis. Another is to stagger maturities and put together a ladder of individual bonds going out 10 years, for example. Thus, a client could hold munis maturing from 2011 to 2020. In 2011, redemption proceeds could be reinvested in 2021 munis, maintaining the ladder. If rates have increased, then reinvestment would be at higher yields.

Ratings risk. Another concern stems from a shake-up in bond ratings. Historically, there has been more risk in A-rated corporate bonds than in A-rated municipals. The same holds true for AA-rated bonds, and so on. In response, the ratings agencies are upgrading their ratings on some municipal bonds.

Moody's and Fitch have both announced that they will recalibrate their bond ratings so that corporate and municipal bond ratings have the same level of default, says Bob Fields, municipal product manager at Pimco in Newport Beach, Calif. "Muni defaults have been much less frequent than corporate bond defaults, so some municipal bonds will have improved ratings even though their creditworthiness is not any better than it was yesterday," he explains. Recalibration already has raised eyebrows in the muni market, with some issues rated three notches higher under the new system, Gonze says.

DEFAULT LINES

The biggest threat to muni investors is default. It is more ominous than widening spreads, interest rate increases or paying AA prices for munis that formerly deserved A ratings. Should a muni bond fund default, investors face a lack of income, illiquidity and ultimately a sharp loss of principal.

Default fears increased during the 2008 recession. As jobs were lost and the real estate bubble burst, muni issuers saw income, sales and property taxes decline, straining their ability to service their debt.