For older investors, municipal bonds can offer diversification as well as tax-free income. Getty Images By Eleanor Laise, Senior Editor October 18, 2018From Kiplinger's Retirement Report Municipal bonds started 2018 with a whimper. Will they go out with a bang?SEE ALSO: How 10 Types of Retirement Income Get Taxed (Including Munis) The Bloomberg Barclays Municipal Bond index fell sharply at the start of the year, as investors fretted that new lower tax rates would diminish demand for tax-exempt bond income and that rising interest rates would push down muni bond prices. But the muni market proved more resilient than many investors imagined. “You have the economy humming along, which means tax revenues are strong” for municipalities, says Terri Spath, chief investment officer at Sierra Investment Management. And investor appetite for muni bonds remains robust, she says. “People don’t like to pay taxes, regardless of the tax code.” For older investors, muni bonds can also offer diversification. Because of the unique factors driving their performance—such as shifts in a municipality’s tax base—they tend to have low correlation with other fixed-income investments. Advertisement Tax reform has been a mixed bag for muni bonds. On the down side, the sharp reduction in the corporate tax rate has diminished corporate buyers’ interest in munis. But other tax law changes paint a brighter picture for the muni market. For many higher-income individuals, the slight reduction in income tax rates is outweighed by the $10,000 limit on state and local tax deductions. That gives tax-sensitive investors in high-tax states such as New York and California extra incentive to seek out the tax-free income of muni bonds. A few other factors are working in muni bonds’ favor right now. After a huge spike in issuance in late 2017, the supply of muni bonds has been more constrained this year, helping to support prices. And municipal defaults, which have been historically rare, have lately dropped to their lowest level since 2008, according to investment-management firm Nuveen. Longer-term munis look particularly attractive now, money managers say. For an investor in the 37% tax bracket, a taxable bond would have to yield 4.32% to equal the 2.72% tax-free yield of 10-year munis. The 10-year U.S. Treasury yields just 3.2%. Longer-Term Munis Ripe for Picking While attention has been focused on the flattening Treasury yield curve—meaning longer-term Treasuries offer meager additional yield compared with short-term Treasuries—the muni yield curve remains relatively steep. As of early October, investors can pick up nearly 0.7 percentage point of additional yield in 10-year versus two-year munis, compared with 0.35 percentage point in 10-year versus two-year Treasuries. Advertisement Although longer-term munis are vulnerable to rising interest rates (as rates rise, bond prices fall), investors can trim the risk by pairing these holdings with short-term taxable bonds. Short-term Treasuries look particularly attractive right now. (See “U.S. Treasuries: Higher Yields Without the Risk”.) Vanguard Long-Term Tax-Exempt (VWLTX) is one long-term muni fund favored by investment-research firm Morningstar. The fund avoids loading up on riskier sectors, such as tobacco and Puerto Rico bonds, and charges low fees of just 0.19% annually. Some managers are also finding bargains among muni closed-end funds, which tend to focus on longer-term holdings. Closed-end funds have a fixed number of shares that trade on an exchange, and their share prices can diverge from the value of their underlying holdings. The funds have been beaten up lately because of fears of rising rates, says Jim Robinson, manager of Robinson Tax Advantaged Income, a mutual fund that invests in muni closed-end funds. That has left many muni closed-end funds trading at wide discounts. At the end of September, the average muni closed-end fund traded at an 8.7% discount to the value of its underlying holdings, Robinson says, whereas the long-term average discount is about 3.3%. SEE ALSO: All 50 States Ranked for Retirement Robinson likes BlackRock MuniYield Quality III (MYI), which holds higher-quality bonds and trades at a 13.7% discount, compared with a three-year average discount of 3.7%.