Municipal Bonds: For Widows and Orphans?

When I was in business school earning my MBA in finance, my program was well know in the area of public finance. We had a former graduate then working at Goldman Sachs come up to critique our presentation on the quality of a certain hospital bond. The analysis went on and on, and at the end this market professional asked one question. How will they pay principal and interest when due, and how secure is the stream securing those payments.
At the end of the analysis of the local market, of the staff, specialties, number of beds etc., it all boiled down to that one question.

With the suspect nature of ratings agencies, how does a current holder or potential buyer of bonds in this incredibly diverse marketplace make a decision on the bonds to buy? Unlike the treasury or corporate markets where there are only so many issuers, the municipal market is comprised of thousands, some issuing only once with a principal amount outstanding of under $100,000. How much money is available for investment to achieve the proper level of diversity? What ratings quality range should be considered? What maturity range? What geographic location of issuers should be examined? If you are from a high tax state, should you only limit yourself to bonds from within that state and Puerto Rico?

If the issuer obtained a rating, when was the last time it was reviewed? If it is a small issuer, after the initial rating it has probably never been reviewed. If it is a large and frequent issuer, it can still be rated improperly.
Should a bond fund be considered? What is the distribution of ratings of the bonds that comprise the portfolio? Is it made up of mostly non-rated hospital bonds or investment grade general obligation bonds? There is quite a bit of homework that needs to be done to determine all of these things.

The bottom line is that the municipal bond market is extremely fragmented and diverse, and although more transparent than it had been still somewhat hard to decipher. Tax-free income, particularly in high tax states, is a critical portion of any portfolio. The key is to have an advisor who you have vetted as much as possible, and to shop the recommended bond around as the price and therefore yield can vary substantially.

As in any investment, the saying caveat emptor is the rule.