Yields on tax-exempt bond funds have fallen, but the likelihood of higher tax rates is one reason these funds are still worth a look

The Journal Report

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After double-digit losses in 2008, these tax-exempt investments have climbed along with other bond sectors this year. Muni-bond mutual funds rose 14.4% on average through Oct. 29, according to fund tracker Lipper Inc. Meanwhile, muni yields, which move opposite to price, haven’t seen such low levels in more than four decades.

Such a strong surge isn’t typical for bonds, and it makes some muni-market analysts uneasy. A little profit-taking after this kind of rally makes some sense, says Philip Fischer, municipal strategist at BofA Merrill Lynch Global Research.

The super sale is over, adds Warren Pierson, co-manager of Baird Intermediate Municipal Bond. Still, he believes there’s a place for municipals in many investors’ portfolios.

Some investors might wonder where that place might be. After all, states and other municipal-bond issuers face Draconian budget challenges even as the U.S. economy overall appears to be improving. Tax revenue from businesses, homeowners and workers is down sharply. As a result, services and programs are on the chopping block.

States tend to lag the economy, says Sheila Amoroso, co-director of the municipal bond department at mutual-fund giant Franklin Resources Inc. Next year, she says, is going to be a tough year for states; 2011 probably will be too. Be prepared for potential downgrade risk and headline risk. Bonds often fall in price when their credit rating is lowered or when budget woes are in the news.

Tax Haven

Still, municipal bonds hold appeal on several fronts.

ENLARGE

Gary Hovland

Top of the list: taxes. The Bush administration’s tax cuts are due to expire at the end of 2010. Though it’s an election year, if the economy is healthy there’s a good chance Congress will let the cuts expire for top earners, at least. In that case, the highest marginal federal income tax rate after 2010 could be expected to revert to the pre-rollback level of 39.6% from 35%. If the repeal goes further, those in most lower brackets could expect to pay about three percentage points more in taxes.

Taxes are undoubtedly going to go up, says Mr. Fischer, the BofA Merrill strategist. Congress is going to face a deficit of around $1.4 trillion. The [Obama] administration has made it clear they want to do some large amounts of income redistribution, meaning taxing the wealthy more heavily to increase benefits to lower earners. I would strongly recommend that people believe them.

Cue municipal bonds. Tax-free income, of course, is the main reason people buy them. Munis are exempt from federal tax and also state tax in the state of issuance. Treasurys are free only from state and local taxes. The higher the U.S. and state tax rates, the more valuable the tax-free income of muni bonds and muni-bond funds.

At current yields, munis have a clear advantage over Treasurys for more than just the wealthiest taxpayers, says George Strickland, manager of Thornburg Limited Term Municipal.

The tax-adjusted yields are great, he says. Investors in the 31% and 28% marginal tax brackets, as well as the 35% bracket, will generally do better in a muni bond than buying a Treasury and paying the tax.

To calculate a muni’s taxable-equivalent payout, divide the bond’s yield by 1 minus your marginal tax rate and compare that to a similar Treasury. For instance, for a taxpayer in the 28% bracket, a 10-year triple-A-rated muni with a 3% annualized yield equates to a Treasury yield of 4.2%—3% divided by 0.72 (or 1 minus .28). The 10-year Treasury note recently yielded 3.4%.

Another factor in munis’ favor is basic supply and demand.

Munis are becoming scarcer, largely because upwards of 25% of new debt—mostly long-term obligations—is in the form of federally taxable Build America Bonds. Issuers of these bonds receive a subsidy from the federal government for 35% of the interest payment. The Build America Bonds program is slated to terminate after 2010, but for now it’s a cheaper revenue source for municipalities and is taking supply out of the tax-free market.

‘Slim-Fast Diet’

Supply is on a government-initiated Slim-Fast diet, says Marilyn Cohen, head of Envision Capital Management, a Los Angeles-based investment adviser specializing in bonds.

The supply/demand imbalance is supporting muni prices. Just be sure not to chase yield at the expense of quality. Investment professionals advise sticking to credits with at least a single-A rating, and limiting your risk to bonds maturing in about eight to 10 years. Longer-term bonds are more sensitive to interest-rate swings and don’t provide enough additional yield nowadays as compensation.

It doesn’t make sense to double your maturity and double your interest-rate risk, says Christine Todd, co-manager of Dreyfus/Standish Intermediate Tax Exempt Bond.

Individual Bonds or Funds?

When do individual munis make sense? When you can afford them and know what to look for.

Diversification mitigates the risk that a bond issuer will default, but for that you’ll need enough money—at least $250,000, Ms. Cohen says—to build a portfolio with at least 15 to 20 bonds of varied types and maturities. Prices of muni bonds, and investment advice, can be found online without charge at the Bond Market Association’s Web site, investinginbonds.com .

Focus on high-quality, investment-grade bonds that are easily traded and reflect many locales and purposes, says John Cummings, manager of Pimco Municipal Bond. His favorites are those issued for essential services, such as water, power and sewers. As long as people keep paying their bills, these bonds will have no problem with cash flow and interest payments. That said, pay attention to an area’s economic health, he advises.

One less-obvious muni-bond investment to consider is public colleges and universities, Mr. Cummings says. Big state universities are excellent credits, he notes. A lot of times they’re better than the state they’re in.

Most investors buy munis through mutual funds and index-tracking exchange-traded funds.

Both actively managed funds and those that follow an index offer built-in diversification, so if a credit implodes it doesn’t take a big chunk of your money. Make sure the fund company fields a strong research group that’s dedicated to muni bonds.

Also, study the fund’s portfolio to gauge the risk it takes to generate return. Muni-bond defaults, while rare, are nonetheless expected to increase. Be careful of any fund that delves into speculative areas, such as below-investment-grade bonds, or uses leverage. If this is not evident in the fund’s literature, call the company.

Moreover, pricing is crucial. What you pay to own a fund comes directly out of total return, so choose products with low expense ratios. Exchange-traded funds are inherently low-cost. Some national muni bond ETFs to consider: iShares S&P Short Term National Municipal Bond. iShares S&P National Municipal Bond and SPDR Barclays Capital Municipal Bond. Many ETF providers also offer single-state muni funds.

No less important is how much a fund manager pays for a trade. Big fund companies can execute trades cheaper, which keeps your costs down as well.

Expenses are a big factor in outperformance over a longer time period, says Miriam Sjoblom, associate director of fund analysis at investment researcher Morningstar Inc.

Vanguard Group Inc. is the low-cost leader among traditional mutual-fund providers, featuring a full lineup of single-state and national muni funds, including two Morningstar Analyst Picks: Vanguard Intermediate-Term Tax-Exempt and Vanguard High-Yield Tax-Exempt.

Morningstar also recommends muni products from Fidelity Investments and Franklin Resources. Like Vanguard, each has experienced researchers and traders, Ms. Sjoblom says.

A safety first approach is appropriate, she says. You could come to a period where your muni fund could suffer a loss, she says. Be prepared, and have a long-term mindset.

Mr. Burton is a writer and editor for MarketWatch, based in San Francisco. He can be reached at jburton@marketwatch.com .