Munis Today: Lots of Yield, without All the Risk

Last year was a stressful year for many bond investors. 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 most bonds' yields rose. That hurt the value of current bondholders' securities. Treasuries were one of the few--if not the only--safe havens during this time. (Over the 12-month period ended Feb. 13, 2008, the yield on the 10-year Treasury fell by about 1%.) We continue to receive questions from the press and subscribers about which areas of the bond market look attractive now, and we keep coming up with the same answer that we did in fall 2007: munis.

An Imperfect but Useful Comparison
Munis don't make for the easiest of comparisons. But one factor that we can accurately assess is their credit risk versus those of 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 about 3.8%, while a representative AAA muni yields 3.4%. However, on a tax-equivalent basis, the muni's yield jumps to 4.7% for those investors in the 28% tax bracket. And for those in the 35% bracket, the yield jumps to 5.2%. At these levels, we think munis' additional yield--taking into account their tax advantages--over Treasuries more than compensates for their modestly increased credit risk. And they're competitive with high-quality bonds from both  General Electric (GE) and  Citigroup (C), which yield about 5.2% and 5.5%, 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 or General Electric would default on its obligations, their businesses are still subject to factors that are difficult to predict one year from now, let alone 10 years out. Citigroup's performance in the last six months is a prime example. It has had to raise billions in new capital to repair its balance sheet, and its losses jolted investors back into remembering that banks' leverage, if not used wisely, can come back to haunt them.

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 2018. 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 67% of munis rated BBB or higher fall into one of these two categories.

As analyst David Kathman wrote in this recent article, bond insurers' recent issues have thus far weighed primarily (though not exclusively) on the equity funds that own these insurers' stocks, rather than on the municipal bonds they insure.

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 4.92% 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 midquality bonds. (Morningstar's Director of Mutual Fund Research, Russel Kinnel, elaborated on these qualities in a Fund Spy article in 2007.)

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 that 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 Alternative Minimum Tax: 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. Last year, Vanguard sold 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--its taxable-equivalent yield for an individual in the 28% tax bracket stands at 4.97%--but it keeps AMT exposure to 0%.