Muni bonds look like a safe haven

Ever since the subprime-mortgage mess hit the fan in August, bonds have seemed less like a safe haven.

Although mortgage-related troubles directly affect just a small slice of the bond market, trouble in that sector triggered a widespread sell-off of virtually everything that didn't have the word Treasury in its name. As a result, ultra-safe Treasuries have soared in price (their yields have fallen), and just about every other kind of bond has suffered.

With interest rates on long-term bonds as low as they are — the 10-year Treasury note recently yielded 4.2 percent — there's little incentive to extend maturities. And although the economy is weakening, the Federal Reserve may not have the flexibility to cut short-term interest rates any more. It doesn't want to take steps that could accelerate the dollar's fall — which, along with soaring oil prices, could fuel a rise in inflation.

One category that looks relatively attractive is tax-free municipal bonds. Munis aren't cheap by historical standards, but they're reasonable compared with today's elevated Treasury prices.

"Because of their high-quality nature, they're a good place to hide in today's environment," says Christopher Burdick, of the Schwab Center for Financial Research.

Munis may look even better if the Democrats sweep the 2008 elections. If that happens, higher federal income-tax rates are likely. That would make munis' tax-exempt features much more appealing. And if Congress allows the current low tax rate on stock dividends to expire at the end of 2010, a lot of money could shift from dividend-paying stocks into munis, says Lisa More, director of Wilmington Trust Investment Management.

If you'd rather leave the bond picking to a pro, our top tax-free fund pick is Fidelity Intermediate Municipal Income (symbol FLTMX; 800-343-3548). It recently yielded 3.6 percent, equivalent to 5.1 percent for someone in the 28 percent tax bracket and 5.6 percent for a 35-percent-bracket taxpayer.

If you want higher yields, a relatively safe choice is a bank-loan fund. A good choice is Fidelity Floating Rate High Income (FFRHX; 800-343-3548). It recently yielded 6.7 percent, but be aware that it lost 4 percent of its value in a single month last summer during the subprime-related bond-market turmoil.

The falling dollar also means that investors get a bonus from holding bonds in foreign currencies. Plus, foreign bonds can lower a portfolio's overall risk. Julius Baer Total Return Bond (BJBGX; 800-387-6977) can invest up to 40 percent of its assets in foreign bonds and has returned an annualized 6 percent over the past five years.

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David Landis is a contributing editor to Kiplinger's Personal Finance magazine. Send your questions and comments to moneypower@kiplinger.com.