DeborahLevine

Reuters

SAN FRANCISCO (MarketWatch) — Yield-hunting investors who are willing to endure a little short-term volatility might want to consider municipal bonds.

Munis now? What about the heated debate in Washington, where lawmakers are mulling changes to the favorable tax treatment of debt sold by states, cities and other municipalities, as well as nonprofit organizations?

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The interest earned on most municipal bond holdings is exempt from federal income taxes (and in many cases state and local income taxes).

But faced with the challenge of how to curb spending and raise revenue, politicians could decide to tax muni interest or in some way limit the tax break. Read more: Muni bonds at risk in deficit debate.

Difficult as it might be, look beyond the headlines. Muni bonds deserve closer inspection because, simply put, they often carry higher yields than their taxable counterparts. Moreover, credit quality is likely to improve with the economy.

“With a reasonably favorable credit environment for municipalities, we still expect muni bonds will be the place to be,” says Matt Tucker, head of fixed income strategy at iShares, a unit of investment giant BlackRock Inc.

Yield signs

The highest-quality, AAA-rated 10-year muni bonds yield about 1.76% — on par with similar Treasury yields but worth more if you’re in one of the higher tax brackets.

“Once you decide what your allocation to fixed income is, you look for the best alternatives within fixed income — and munis make the most sense,” says Thomas Metzold, a manager of the $5.1 billion Eaton Vance National Municipal Income Fund EANAX, +0.20% which gained 14.1% this year through Dec. 26, according to investment researcher Morningstar Inc.

Municipal bonds of all maturities have returned 7.2% so far in 2012, according to an index compiled by Bank of America Merrill Lynch. The index’s effective yield is 2.6%.

At the same time, the firm’s Treasury bond index has returned about 2%, and its effective yield is just under 1%.

Metzold cautions that the muni market is unlikely to duplicate such strong performance again in 2013 because interest rates fell so dramatically this year. Bond prices rise when interest rates decline.

“Next year, we look to clip the coupon, which isn’t bad in a low interest-rate environment,” he says. Meanwhile, he adds, the alternatives for income investors are hardly attractive: certificates of deposit and money-market accounts, for example, offer close to zero-percent return and in fact lose money after factoring in taxes and inflation.

Still, the federal debate over munis’ tax-exempt status bears watching. The topic has come up in the past and the tax exemption survived because it was deemed an effective subsidy for state and local governments that benefitted their citizens.