Are Municipal Bonds a Smart Choice for Investors?

Municipal credit is going through a challenging time with concerns over the ability of many states—such as New York, Illinois and California—to withstand the sluggish economy and growing deficits. So are municipal bonds the smart choice for investors?

"With muni's (municipal bonds) you have to take your tax rate into consideration, the lower your tax rate the less attractive muni's are," Ben Thompson, founding principal of Samson Capital Advisors told CNBC's "The Strategy Session" on Monday.

"If you are a full tax payer in the U.S., this year you are paying 35 percent. If the Bush tax cuts expire, next year, you'll be paying 39.6 percent. So the value of tax-free income just rises as your tax rate rises," said Thompson.

"State and local governments had seen deficits last year under $190 billion and this year they are going to face $120 billion to close when they finish with this fiscal year—the challenges are still there," Thompson went on to say.

But Thompson quickly added that the high-quality muni market is still very strong. For example, the New York City Transitional Finance Authority (TFA), has a yield of 2.87 or 2.90 with a AA or AAA rating.

Also, the "likelihood of a state running into true cash-flow crunch is extremely low" because they don't have roll-over risk, he said, adding, states don't have "that impending need for massive borrowing," he said.

"California is the only state that has tested this by habitually doing short-term borrowing to bridge that (budget) gap," Thompson said. Every time "the market has let them in at relatively high rates with the belief that the state will ultimately meet their cash flows," Thompson argued.

The question is, Thompson said, who are the strong states, who are the weak ones, who has the political will to make the right decisions, make the hard choices to balance the budget, "to basically set up their economy for growth in the future."

Related Links:

CNBC Data Pages:

Programming note: "The Strategy Session," hosted by David Faber and Gary Kaminsky, airs weekdays at Noon ET on CNBC.