In this article, we’ll look at some of these risk factors, and how investors can avoid problematic muni bonds and properly position their portfolio.

The Great Recession may have ended in mid-2009, but the impact is still being felt in the municipal bond market. According to PNC, approximately 20% of the muni market has a deteriorating or structurally imbalanced credit profile. These municipalities are experiencing slow-growing revenue and rising expenditures that put them on unstable ground. Another recession could put these issuers under pressure and spark another wave of defaults.

Over the long term, many municipalities also suffer from pension obligations that are underfunded and coming due in the next few years. These pensions were established during good times when the muni market yield was averaging 8% per year, but slowing returns have made it increasingly difficult for these companies to maintain payments. Some analysts believe these dynamics could cause as many as 50-100 sizable defaults.

Many of these risks have been obscured by significant investor demand for muni bonds, which has helped yields move lower. Issuers have taken advantage of these market conditions to issue low cost debt to avoid making tough decisions that eventually need to be made. These actions could help in the short term, but increasing debt service obligations only exacerbate these problems over the long run – and investors should be wary.

Interest rates pose another significant risk to the municipal bond space. If interest rates move higher, bond yields will increase and bond prices will fall. Falling bond prices could hurt muni bond investors who don’t plan on holding the bonds to maturity, such as short-term investors in muni bond exchange-traded funds (ETFs). The exact timing of an interest rate hike remains uncertain, but could happen before the end of the year.

A specific muni bond’s interest rate risk depends on its duration, with longer-term bonds at a greater risk than shorter-term bonds. In particular, investors can use a bond’s duration to visualize its interest rate risks in a single number. Duration is defined as the amount by which a bond’s price may increase or decrease in response to a 1% change in interest rates. A duration of three means that a bond will fall 3% if interest rates rise 1%.

Investors can take a number of different actions to protect their portfolios from these risks without avoiding one of the strongest-performing asset classes in recent years.

The first step is investing only in high-quality muni bonds. While some cities are facing budget issues, the vast majority of the market remains strong and worthy of investment. The best way to do this is to focus on bonds with AAA credit ratings, and avoid those with low-quality or junk ratings. In addition, investors should ensure that they’re holding a diverse portfolio of bonds, rather than a concentrated number of bonds in a single geographic area.

The second step is ensuring that muni bond holdings are prepared for an interest rate hike by reducing duration through shorter-term bonds. While these bonds don’t pay as high of yields, they may offer better risk-adjusted returns for those who aren’t planning on holding the bonds to maturity. Those that do hold the bonds to maturity may face an opportunity cost, as bond yields across the board rise in response to higher interest rates.

Investors shouldn’t assume that municipal bonds are immune to risks, even if yields are on the decline and the economy is improving. In approximately 20% of cases, municipalities are facing dangerous budget shortfalls. And the rising threat of higher interest rates could translate to lower bond prices across the board. Investors should carefully consider these risks, and position their portfolios appropriately to mitigate potential losses.