Steals in Tax-Free Bonds

Municipal bonds are a good bet. At least, Warren Buffett thinks so. Buffett's Berkshire Hathaway plans to start its own municipal-bond insurance business. And Buffett has offered to let existing muni-bond insurers pay Berkshire to handle some of their current business. So far, none of the insurance companies has taken him up on his reinsurance proposal.

When Buffett made his pitch to the bond insurers, their stocks surged. According to the instant analysis, Buffett's seeming vote of confidence ignited the rally. But that assumption was wrong. If Buffett were endorsing the insurers, he would have bought their stocks. Or, if he thought there was value in the companies' mortgage-insurance business (the heart of their current problems), he could have offered to reinsure those securities.

Why worry? No, Buffett was interested in the one thing that the insurers haven't messed up: muni bonds. It's easy to see why. Bond insurers' woes have depressed municipal-bond prices to the point of silliness. In some cases, insured munis have been sold down so far that they yield the same as uninsured munis, implying that the insurance has zero value. Prices of uninsured munis have also fallen. None of this makes sense. Even during a recession, issuers almost always make good. The ten-year average cumulative default rate among municipal issuers is 0.1%, according to Moody's.

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Munis also look good compared with U.S. Treasury bonds. Because interest from munis is generally exempt from federal taxation, munis must offer yields equal to those of Treasuries minus your tax rate to be attractive. Historically, that meant you needed to be in the 28% bracket or higher. But munis are so cheap now that they are a good deal even for people in the 15% bracket. In short, munis are a steal. That's particularly appealing in a weakening economy, when defaults in other parts of the bond market will likely rise.

To check whether you should buy a muni bond fund, compare its current yield with that of a similar, high-quality taxable bond fund. Then find a taxable-equivalent yield calculator, such as the one at Morningstar.com. Plug in the yields and your tax rate to see which fund offers the better deal after taxes.

You're better off buying funds that invest in munis than buying the bonds directly. First, a fund gives you diversification, which means you don't have to worry about defaults; if any occur, they will have a minimal impact on your fund. Second, your fund will get a much better price on the bonds than you can.

As long as you're managing your tax bill, you might as well steer clear of the alternative minimum tax by buying a fund that doesn't own AMT bonds. Among my favorites are Fidelity Tax-Free Bond (symbol FTABX), T. Rowe Price Tax-Free Income (PRTAX) and Vanguard Long-Term Tax-Exempt (VWLTX). Fidelity Tax-Free has low costs, excellent management and a sound strategy based on issue selection. Its initial minimum investment is $25,000. Vanguard Long-Term Tax-Exempt recently changed its policy to exclude bonds subject to the AMT, making it a welcome addition to the AMT-free club. For as little as $3,000, you get a broadly diversified, high-quality portfolio that charges annual fees of just 0.16%. The T. Rowe Price fund isn't as cheap as the other two, but it does a nice job of moderating risk.

I'd skip closed-end muni funds for the moment. The rolling credit crisis has struck at the market for auction-rate debt securities, the mechanism that closed-end munis use to borrow money to boost their yields. Buyers have stopped showing up at auctions and yields have soared, which means that borrowing costs are climbing for leveraged closed-end funds. Until confidence has been restored, stay away. (See our take on closed-end muni funds.)

Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.