Looking for Yield? Look at Munis

It's no secret many bond investors took it on the chin this summer. Concern over defaults in subprime mortgage-backed securities, initially contained to that corner of the fixed-income arena, eventually burst into the rest of the bond market, as market liquidity dried up and bond yields spiked. We've received a lot of questions from the press and subscribers about what areas of the bond market look attractive now, and we keep coming up with the same answer: munis.

Comparing Apples to Apples, Sort of
Munis don't make for the easiest of comparisons. But one factor we can accurately assess is their credit risk versus other fixed-income asset classes. For example, the default risk of U.S. Treasuries is virtually nil, so they're less risky than munis. But high-quality munis are a safer bet than corporate bonds. So to start our comparison, we put the highest-quality municipal issues side-by-side with Treasuries. And because only a small percentage of investors and managers buy only Treasuries without diversifying into other government-backed paper and U.S. corporate bonds, we also looked at AAA munis' attractiveness versus a handful of well-known, AAA rated corporate issuers.

The 10-year Treasury yields 4.59 %, while the AAA muni yields just 3.85%. However, on a tax-equivalent basis, the muni's yield jumps to 5.35% for those investors in the 28% tax bracket. And for those in the 35% bracket, the yield jumps to 5.92%. And that compares favorably with AAA bonds from both General Electric and Citigroup, which yield 5.61% and 5.75% respectively. (Try out our muni tax calculator to find out more).

And as hard as it is to imagine that a company such as  Citigroup (C) or  General Electric (GE) would default on its obligations, its business is still subject to factors that are difficult to predict one year from now, let alone 10 years out.

By contrast, it's a safe bet that in 10 years, the commonwealth of Virginia--which Fitch rates AAA--will still be free to collect taxes to meet debt and principal payments on general-obligation bonds maturing in June 2017. And across the nation, munis are often insured (the issuer buys default insurance from a handful of AAA rated insurance agencies) or prerefunded (meaning they're backed by U.S. Treasuries). In fact, according to S&P data, about 66% of munis rated BBB or higher fall into one of these two categories.

Great Muni Funds for the Long Haul
Individual municipal bonds can be a good option for some investors, but mutual funds can save investors time, stress, money, and, as it turns out, still generate some healthy income.  Fidelity Municipal Income (FHIGX), for example, offers a current tax-equivalent yield of 5.38% for investors in the 28% bracket. That's in line with the yield offered by  Fidelity Investment Grade Bond (FBNDX), but the municipal fund comes with less credit risk.  Vanguard Long-Term Tax-Exempt (VWLTX) and  Franklin Federal Tax-Free Income  (FKTIX) also offer compelling yields. And all three boast low expenses, experienced managers and analyst teams, and an aversion to riskier mid-quality bonds. (Morningstar's Director of Mutual Fund Research Russel Kinnel elaborated on these qualities in a Fund Spy article earlier this year.)

Muni Income: It's Not All Tax-Free
While the tax advantages of these funds are clearly hard to contest, there is another consideration. Many fund families offer a wide selection of state-specific muni funds. We think these funds make great options for investors in states that levy taxes on income from munis issued outside state lines. And, the managers of state-specific funds are often the same ones at the helm of nationally diversified offerings, lending them a broader perspective on overall market trends.

A final note for investors paying AMT: You'll want to pay attention to a fund's AMT exposure because it can eat into munis' tax advantage. It's generally listed--sometimes in hard-to-find corners of fund company Web sites--as a percentage of assets. In early 2007, Vanguard moved to sell any bonds subject to AMT in its investment-grade muni funds. Current exposure at both Franklin Federal Tax-Free Income and Fidelity Municipal Income is less than 10% of assets. And for Fidelity investors who can invest a higher minimum amount,  Fidelity Tax-Free Bond (FTABX) is nearly identical to Municipal Income, but it keeps AMT exposure to 0%.