Default rates on munis are pretty low. But, in the worst case scenario, yes, you do lose if you buy munis that aren't insured and the issuer doesn't have the capital to pay dividends or redeem the principal. A municipality in bankruptcy would have its bond rating seriously downgraded but could probably attempt to issue new general obligation bonds to bail themselves out - but who in their right mind would buy them?

Insured bonds have a slightly lower yield and appeal to the more conservative among us. With insurance, no matter what happens to the finances of the government that issues the bond, the bond's interest and principal payments will be made.

There's a lot being written about selling off bonds and buying Treasuries. Those are about as safe as you can get - barring a total collapse, but they don't pay much. Still a good place to park funds for a short term or two years if you can accept a tiny discount and yield of 2.225%.

"What happens to dividends on existing bonds when the issuing municipality fails? Do the bonds become worthless, or is it just that the municipality can't raise funds by issuing new bonds?"

The answer to your question can be found at FINRA:

Auction Rate Securities: What Happens When Auctions Fail

April 30, 2008 Updated

Unfortunately, due to recent developments in the credit market�"including downgrades in the credit ratings of bond issuers and bond insurers�"a significant number of auctions have failed, leaving some investors who counted on immediate access to their funds wondering about their options.

What alternatives are available?

ARS investors should read the offering documents carefully to determine what, if any, provisions the issuer has made in anticipation of illiquidity and failed auctions. Some issuers of bonds or preferred shares may have reserved the right to convert the ARS into a fixed or variable rate security or to call the instrument at a certain price.

ARS investors who want to liquidate their holdings�"but cannot because of failed auctions�"have a variety of options. These include: (link below).

Links that might be useful:

www.finra.org/InvestorInformation

www.moneyandmarkets.com/Issues.aspx?NewsletterEntryId=1707

It does begin to seem like the old mattress is as useful as Treasuries! LOL

Seems there's nothing outside of the stock market that will beat the REAL rate of inflation -- which is NOT the 'gubmit' figure as far as this Senior is concerned.

Auction rate securities, while usually generating tax-exempt income, are typically asset backed securities (student loan backed) or corporate bonds. The corporation was formed for the purposes of making student loans. They got hammered in the mortgage backed securities whumping last year. Auction rates are not straight, garden variety munis and shouldn't be confused.

Each municipality's situation could be different in the event of municipal bankruptcy. Municipal bankruptcies are very very rare. You first off must know if the bond you are looking at is backed by taxes or revenues. If you own an outstanding tax-backed bond, it's value obviously declines but it could still be paid off on schedule because some amount of taxes will be collected. If your bond is backed by the revenues of a project, you need to know how the project is faring (ie water or sewer revenue - don't people still need these services). New bonds couldn't be issued at current market rates, if at all.

I don't think there's an easy answer to your questions, sue, because the world of munis is huge and each situation could be different. However, if you are considering investing, make sure you know the underlying rating of the municipal entity before any insurance was added (which gave the bond it's AAA rating).

When I Googled this topic I learned that in most cases where a municipality is considering declaring (Chapter 9?), the state will pony up to prevent it from happening.

So, these events are rare in the recent past, but were a real concern in the Depression -- before there was a bankrupcy 'out' for municipalities.

What I read indicated that one of the benefits for a municipality in banckruptcy was the ability to re-negotiate employee contracts. (Better for the town than for the individual employees; trickle-down, etc.; not a pretty picture for that area's economy.)

I would never be asking these questions had we not just had this big wake-up over RE and hedge funds and all the market-driven houses of cards.

Thanks for bearing with me as I try to understand what's happening.

Sue, Please keep in mind that the states are not legally obligated to pony up and help out the cities. Also, if a muni is issued for a specific project, it's typically going to be paid back by the revenues of the project. For example, the Chicago Skyway was built and financed by revenue bonds in the late 1950's/early 1960's. The bonds went into default in 1964. Neither the City of Chicago nor the state of IL did anything to bail out the bonds/bondholders...nor were they obligated to. The bonds were in default for about 30 yrs. During that time, the city of Chicago paid/covered most of the operating costs and those funds weren't reimbursed. So, this has nothing to do with employee contracts being renegotiated. For any revenue bonds, general operating funds are not used to repay the debt and, therefore, cutting those operating costs won't make any difference.

General obligation bonds, bonds which by definition are repaid by general tax collections, could be impacted by things like cutting expenses. But then there are also limited tax obligation bonds (repaid by just 1 tax - ie library bonds repaid by library tax collections and only cutting library employee expenses could affect repayment of those bonds).

The trick is that when one says "municipal bonds", they are talking about a large category of tax-exempt debt and unless one knows how the legal agreements are structured regarding debt repayment, one will mess themself up when making generalizations.

I just ended a 35 yr career working in/around munis - and I still get confused by them!

This is just the most wonderful, helpful forum -- thanks to people like you, kec01! At least I now know what I don't know, which could save me a world of trouble.

One other thing...over the last recent number of years, many municipalities purchased insurance (MBIA or AMBAC or others) and that got the bond issue a Aaa rating. If you take away the insurance, the municipality is still going to have a rating on it's own. I would GENERALLY regard a Aa rated bond as a decent investment, at the right price. I'd want to see credit write-ups, though, from municipal bond researchers before I made a purchase. These should be obtainable from a broker.