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By Christine Benz and Miriam Sjoblom, CFA | 02-25-2013 12:00 PM

4 Bond Funds for Your Taxable Account

Muni-bond funds continue to experience high investor demand, and Morningstar's Miriam Sjoblom offers picks for core and noncore holdings.

Christine Benz: Hi, I'm Christine Benz for It's Tax-Relief Week on, and joining me to share some top municipal-bond fund picks is Miriam Sjoblom. She is associate director of fund research for Morningstar. Miriam, thank you so much for being here.

Miriam Sjoblom: Glad to be with you, Christine.

Benz: First, I'd like to ask a really basic question: Why are municipal-bond funds and bonds often touted as a good fit for peoples' taxable accounts?

Sjoblom: Well, this is unique to municipal-bond funds. Their interest is exempt from federal income tax, and in many cases, if you live in a certain state, your interest is exempt from state income tax, as well.

Benz: So if you buy a bond issued by your home state or if your fund is dedicated to bonds from that home state, some or all of that income might be exempted from state income tax?

Sjoblom: Right. The biggest specialty states--they're called specialty--are New York and California. So, oftentimes, you find residents of those states like to buy bonds issued in those states.

Benz: Miriam, I'm wondering if you can kind of summarize munis today? We had a really nice rally, especially in some of the lower-rated munis in 2012. As you look forward and think about some positives for the category as well as where the challenges lie, let's talk about them.

Sjoblom: Sure. Well, with some of the challenges, it's similar to the challenges we're seeing across the bond market. After a rally like we saw in 2012, you're starting the year 2013 with yields at very low levels, and a lot of the return last year came from price appreciation, not income. So, starting at an already very low level of yields, there's very little room for yields to drop further.

Benz: So that's the negative side. Any reason for optimism as you look forward and think about states' finances perhaps.

Sjoblom: Well, there are a couple of reasons for optimism. They're more related to the technical dynamics of the market. Last year, we also saw a lot of demand into mutual funds especially. We had about $50 billion coming into muni funds altogether. So that seems to be remaining strong so far. Just in January, we had another $7 billion coming into muni-bond funds, and they're going mostly into intermediate funds as well as some high-yield muni funds. So, if investors continue to like the tax exemption and the benefits of muni funds as they have been, that will be supportive of the market.

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