As turmoil persists, municipal bond funds look good

The focus in tax-advantaged investments in a tumultuous market has turned to municipal bonds.

The traditional benefit to investors of the $2.6 trillion muni market is interest income exempt from federal tax and, in many cases, from state and local taxes, though municipals issued for certain purposes may not be.

As financial markets gyrate on talk of recession, interest rate cuts, tax cuts and troubles of bond insurers, municipal bonds have become much cheaper to buy and their yields more like taxable bonds.

"Almost anyone in the 28 percent tax bracket or above should be considering municipal bonds, and we advise they stay with short-to-intermediate-term, high-quality bonds," said Harold Evensky, certified financial planner with Evensky & Katz, in Coral Gables, Fla. "There's a good deal of risk and very little reward for extending bond maturities out beyond 10 years."

Although muni bonds historically offer about 80 percent of a comparable Treasury's yield, today their yield is about the same even though munis have a tax advantage, Evensky said. The yield increase is because of fears about the credit crunch and bond insurers.

An investor with a diversified portfolio of municipal bonds faces little risk, Evensky said. He considers this a buying opportunity, and uses municipal bond mutual funds of the Vanguard, Fidelity, Thornburg and Schroder fund families for his clients.

"Municipal bonds are definitely attractive right now because the equity markets are up and down every day, while tax brackets are not going any lower," said David Bendix, certified financial planner and certified public accountant with Bendix Financial Group, Garden City, N.Y. "If you're creating a fixed-income allocation and in a high tax bracket, it just makes sense to have munis."

Bendix favors muni funds from Franklin Templeton, Rochester and Nuveen.

Investors in municipals should have a buy-and-hold mentality, experts said, weathering inevitable storms of credit risk and shifting rates. Mutual funds that invest in a portfolio of munis offer diversification not possible if an investor buys single bonds. The fund managers also seek bonds with reasonable risk. Intermediate-term funds with munis maturing in three to 10 years offer good yields without much volatility.

Downgrading of the credit ratings of insurers of municipal bonds is factored into the bonds' discounted prices, and actual bond default rates are extremely low. It does whack their prices in the short run, and an investor's principal can go down. But plenty of investors with a longer time horizon still see the advantages of munis.