Will California's budget crisis whack your munis?

The safety of municipal bonds is often taken for granted. After all, the theory goes, if a state or city runs short on cash, it can always tax the heck out of its constituents to make up the shortfall. Corporations, on the other hand, don't have that kind of fallback.

But California's recent budget troubles have thrown the default possibility back into the limelight. And that might have you wondering if you should bail out before yet another theoretically safe investment proves to be not so secure after all.

If you haven't been paying attention, California seems to keep getting closer and closer to default, and its government can't decide how to clean up the mess. Fitch Ratings recently downgraded the state's bonds to the worst in the country (which happens to be A-, a rating many corporations would kill for). While the spokesman for California's Treasury department says a default "won't happen," could you ever imagine a Treasury spokesman saying default was "kind of a possibility"?

Despite all the recent trouble, however, you probably shouldn't start fleeing muni bonds. That's not because there's no chance some muni bonds might default. It's because muni bonds are paying enough money to make that slight risk worth taking.

Let's start off this discussion with what should be your central question: "What do I have to lose?"

In the case of muni bonds, the answer is "Not much." For one, single-A rated municipal bonds have a historical default rate of 0.0084%. That is, only about 1 in 12,000 defaults over a 10-year period.

But let's say you hit that unlucky jackpot. Your state says, "To heck with our creditors. We don't care if we won't be able to borrow money again for years," and refuses to pay. Then what do you have to lose? The answer still is, "Not much." In fact, according to the Wall Street Journal, in the Great Depression, while more than 15% of muni bonds defaulted, the estimated loss rate for investors was 0.5%. When Orange County, Calif. defaulted in 1994, investors actually got all of their money back.

And here's what you have to gain: Right now, 5-year muni bonds are yielding 2.14%, which is the same as 2.97% if your income is taxed at 28%. That's compared to a 2.44% yield on 5-year Treasury bonds.

Let's say you're weighing the purchase of a 5-year muni bond in its typical, $5,000 denomination against the purchase of a risk-free Treasury bond. Are you willing to risk a 1 in 12,000 possibility that you lose $25 (0.5% of $5,000) for the 11,999 in 12,000 chances of making an extra $125 over 5 years?

For me, the answer is yes. But if the 0.0084% chance of a $25 loss from a default frightens you, buy a municipal bond mutual fund that can mitigate your risk even more, such as the Fidelity Intermediate Municipal Income fund [fortune-stock symbol=FLTMX" target]. Mutual funds will have other risks attached. If interest rates rise, fund prices can fall, causing you a larger loss. But in exchange, you'll lose little money even if one of the fund's bonds is completely wiped out.

Now, you could argue that there are even greater opportunities in stocks and corporate bonds, since virtually risk-free assets like Treasuries and municipal bonds aren't offering much income right now. That aside, muni bonds still look like a better bet next to those issued by the U.S.A.