Municipal Bond Funds Take The Spotlight

With yields near all-time highs, even tax-insensitive investors may benefit.

Normally, municipal bond fund returns don’t create a whole lot of hoopla. But these are not normal times. As I first pointed out in April, muni yields traded at an all-time high of more than 125% of U.S. Treasury yields at the end of March—well above the normal range of about 80%. While Treasury yields have since risen, the ratio of muni-to-Treasury yields remains just shy of 100%.

The yield differential is even more eye-popping if you’re in the top 35% income tax bracket. Assume another 9.3% for state taxes, and 10-year municipal bonds show a tax-equivalent yield of 7.18%—almost twice the 3.97% for 10-year Treasury securities.

Municipal bond yields remain attractive

What’s been driving muni bond prices lower and yields higher?

•	Massive selling on Wall Street by distressed hedge funds and financial intermediaries.

•	The early 2008 seizure of the municipal auction-rate market, which wreaked havoc on the pricing of new issues.

•	The deteriorating financial state of several of the biggest municipal bond insurers.

The result: Unique opportunities for income-oriented investors. Even some taxable bond fund managers have accumulated longer-dated muni issues for their attractive yields and diversification characteristics. While yields may have fallen from this year’s earlier all-time highs, AAA-rated municipal bonds continue to outyield similarly dated Treasuries on a pre-tax basis. Therefore, muni bonds may make sense for almost any investor looking for fixed income.

What about risk?

Despite lacking federal government backing, municipal bonds have exhibited considerably lower default rates versus investment-grade corporate bonds. According to a Standard & Poor’s study, BBB-rated munis (the lowest rung of investment grade) have experienced a default rate of less than 0.1% during the past five years, well below the 3.2% rate experienced by BBB corporates during the same time span. Also, the return volatility of AAA-rated munis measured over long time periods is at or below that of similarly dated Treasuries.

Two good 5-star funds that I own for the long run:

1. NOTAX DWS National Tax Free--5 Stars
2. STSMX Wells Short Muni ---------5 Stars

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