8% Returns: The Bond Deals You're Missing

IN THE WORLD OF INVESTING, they went from being a positively boring option to an almost sexy one in a matter of weeks. Municipal bonds, those securities your mom and dad would own and lecture you to buy, toiled in obscurity for decades until the crash made them an almost exciting option for anyone looking for a safe haven. And they remain attractive in today's more encouraging, if still shaky, investment climate as a low-risk product people can own while they're slowly getting back into stocks.

Except for one problem: Investors across the country are discovering that muni bonds -- which can still deliver an aftertax yield as high as 8% in some income brackets -- have become more popular, as well as a lot more complicated and frustrating. Almost overnight it has become nearly impossible for individual investors to get their hands on many top-quality municipal bonds. Even when they can, they're paying higher prices, and many of the bonds no longer have insurance to protect them from a default by the city or town that issued them. And with a new government bond program that favors large institutions, some buyers are feeling the pinch. "It's a market for the other guy, not for us. It makes me feel small," says Delia Fernandez, a financial adviser in Los Alamitos, Calif., who has $20 million under management.

Like many far-reaching changes in the world of investing, the shift in the $2.7 trillion municipal-bond market has its roots in the financial meltdown. Financial planners and bond traders say the combination of the credit crisis and fallout from the government's new bond program has put a big dent in the availability of many high-quality municipal bonds, just as recession-weary investors are fretting about the health of muni-bond issuers. Even as the credit crisis eases, its impact on the muni market continues to reverberate. Several major muni-bond broker-dealers went belly-up in 2008, making it tougher for ordinary investors to buy or sell bonds. But one of the biggest roadblocks has been erected by Uncle Sam himself. The government's "Build America Bonds" program offers states and towns huge incentives to borrow money-but the bonds are hard for individuals to buy and, worse, come without the tax breaks long associated with ordinary muni bonds. The result is that institutions are snapping them up, but mom-and-pop investors looking for tax-free income are out of luck.

Of course, thousands of tax-free muni bonds are bought and sold each day, and investors with well-connected brokers and advisers can still get many of the ones they want-provided they have the required account minimums of several hundred thousand dollars. But for others, the irony in all the changes is that individual investors have long been the backbone of the market, buying some 70 percent of the bonds themselves or through mutual funds. The new problems are all the more galling, some say, because it was these same small investors who helped save the municipal-bond market from a total meltdown last fall. When institutions and hedge funds were flooding the market with muni bonds in a desperate attempt to raise cash, ordinary investors filled the void and bought much of the highest quality debt, says Robert Lamb, professor at New York University's Stern School of Business. Now, as investors try to rebuild their nest eggs, one of their best tools is becoming one of the most difficult to get.

State and local governments have sold municipal bonds ever since New York City kicked things off with a canal bond in 1812. Three decades later the municipal-bond market had grown to $25 million. But it really took off after World War II, as governments sought ways to build new projects and individuals clamored for tax breaks. The idea is simple: Investors who buy bonds are lending cash, for anywhere from one to 30 years, to their local government to build schools, sewers or other big-ticket projects. In return, investors get bonds with a nearly spotless credit history, plus interest payments free from federal income taxes (and state taxes if they live in the state that issued the bond). The higher the investor's tax bracket, the more appealing the bonds become. Because of that tax advantage, municipal bonds historically have offered much lower yields than a corresponding Treasury bond. But today that gap has narrowed, making muni bonds an even better buy. Munis can offer an after-tax yield of about 8 percent. For high-income investors, they could look better still if the top tax rate rises as expected in 2011.