Aren't municipal bonds paying better these days because of fear (justified or otherwise) that lots of them--especially in California--are going to start defaulting?
Quick SEC disclaimer... I'm not an investment professional; I'm just sharing my personal experience.
It depends. Munis come in all flavors and sizes; the best ones IMHO are state-level "general obligation" (i.e. backed by state taxpayers) that do NOT fund revenue projects (this will make them taxable anyways). The second best ones, again in my IMHO, are classified as UTX ("Unlimited Taxation"), which gives the local government the power to raise local taxes in order to pay bonds. The ones I would be most worried about defaulting are the ones classified as LTX ("Limited Taxation") that fund revenue projects like local stadiums or toll roads; these bonds are paid back by the money collected by the underlying asset. Obviously, these would be the easiest to issue, as they do not require a referendum vote like UTX bonds, or state legislature approval like GO bonds.
Some states like California are constitutionally required to pay bondholders before any state-funded programs. Some states (like California) are also legally required to maintain a sinking fund, i.e. they can't make interest-only payments, but must also set aside money to pay back the principle owed to bondholders ever year. The "budget crisis" in California is because after paying back the 2 constitutionally mandated budget items, the state doesn't have enough money to keep the same level of spending as before.
In California, The interest on bond payments is an automatically budgeted line item every year; lawmakers can not change this without making changes to the state constitution.
Interesting, thanks. If I move to a state with income tax, or enter a tax bracket that warrants it, I'll definitely take a closer look at municipal bonds.