Time to Buy Munis

Markets are pretty efficient, yet the patient investor can usually find a good deal. Today, that deal is municipal bond funds. With the stock market taking a beating, finding a bargain that offers steady yields and strong protection of principal is mighty appealing. It makes sense that the stock market is down from its highs. After all, a lot of value has been destroyed in mortgages and housing, and soaring oil prices are crushing a slew of industries.

Dirt-cheap. But the beating that municipal bonds have taken makes less sense. The mortgage mess has indirectly stung munis because the companies that insure mortgages also insure munis, and the insurers' viability is in question. The upshot is that muni insurance isn't worth much these days. So it would make sense for insured munis to slip a bit. Instead, all munis, including those that are not insured, have been punished way too hard. True, we're facing hard times in the economy. Yet in past recessions, the default rate for high-quality munis was about 1% or 2%. On top of that, investors' flight to quality is pushing Treasury yields to very low levels, and hedge funds are dumping munis. Put it together and you get an odd disparity.

Believe it or not, many muni bonds now yield more than Treasuries. Historically, it has been the other way around because their income is not free from federal taxes. Consider that Vanguard Intermediate-Term Treasury fund yields 3.5%, compared with 3.7% for the Vanguard Intermediate-Term Tax-Exempt fund. A year ago, the Treasury fund was yielding 0.8 percentage point more than Tax-Exempt, whereas now it yields 0.2 point less.

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The situation is all the more remarkable when you factor in taxes. Bond calculators, such as the one at Morningstar.com (click on "Tools," then go to "Bond Calculators"), allow you to plug in a fund's yield and your tax rates. Let's assume a 33% federal tax rate and a 5% state income tax. That gives you a tax-equivalent yield of 5.9% for the muni fund and 3.6% for the Treasury fund (Treasuries are free from state taxes). That's a pretty nice margin for error.

Here's the good news about muni insurance: You don't need it. Just buy a muni-bond fund that is low cost, high quality and well diversified -- high quality because this is no time to take on a lot of credit risk, and well diversified because that means the fund can suffer a default or two without damaging returns much. Morningstar Fund Analyst pick Fidelity Intermediate Municipal Income (symbol FLTMX) has more than 800 bonds and only two account for more than 1% of assets. Vanguard Intermediate-Term Tax-Exempt (VWITX), another Fund Analyst favorite, has more than 1,300 holdings and only one is greater than 1% of assets.

Not only do these funds offer a lot of holdings, but their managers have also proved to be skilled at diversifying by sector, state and other factors. Consider that the Vanguard fund hasn't lost money in a calendar year since 1999, when it lost half a percentage point but still beat 90% of similar funds. In addition, fund managers have the skills and time to do in-depth research on credit quality and call features that could lead to the bond being paid off at the worst possible time.

Better deals. A final reason to buy a muni fund rather than a muni: The fund's trading desk is better than yours. The giant fund companies can get much better secondary-market prices than individuals typically get from their broker. Trades of more than $1 million enjoy a bid-ask spread of just 0.14 percentage point, while those of less than $50,000 pay a spread of almost two percentage points, according to data collected by Vanguard. That's a huge gap for a low-risk, low-yield security.

Okay, so a 5% tax-equivalent yield isn't going to make you rich quick. It will, however, boost your portfolio's return and take some of the pain out of the rough times in stocks.

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