The economic downturn has hit some municipalities, illustrating the risks of municipal bonds and exchange traded funds (ETFs) that hold them. But it also highlights the opportunities for investors willing to take on risk.

The city of Vallejo in Northern California has voted to declare Chapter 9 bankruptcy, which allows municipalities to continue to deliver services while adjusting or refinancing debts.

Vallejo is the largest city in California to declare bankruptcy, reports Carolyn Jones for the San Francisco Chronicle.

Municipal bonds are considered among the safest investments one can make, after U.S. Treasury bonds. Unlike with corporate bonds, municipalities and the government can draw
money from plenty of other sources when they get into a bind – raising
taxes, for example. This ability to generate money on a whim makes it
significantly less likely that the bond issuer is going to default.

Unlike a corporation, Vallejo can’t simply shut down and sell off
its assets. But it can take a lesson from Orange County, a now-thriving
area that declared bankruptcy in 1994: it issued municipal bonds that
allowed the county to emerge from Chapter 9 a few years later.

Municipal bonds haven’t been an active area for "distressed investing," say Nicholas Kajon and Lee E. Buchwald for Mondaq.
But such bonds would give opportunistic investors a chance to get in at
low prices. Recovery rates for these municipal bonds are greater than those of corporates.

Vallejo and other municipalities can take a hit in rocky economic times
because they’re often reliant on volatile revenue streams such as
property taxes and real-estate transaction taxes, reports Liz Gunnison for Portfolio. Add in a housing crisis, and you’ve got a mess.

A default is rare, but it’s never good news, Glenn Smith at Van Eck told us last month. "When it does happen, it can throw markets out of whack because people get jittery." According to NPR, it’s only happened in the United States 32 times since 1980.

Hey, NASCAR star Jeff Gordon is from Vallejo. Maybe he wants to kick in a few bucks to help out?

Tags: Bond ETFs