Muni Bonds Paying for Others' Mistakes

It's hard to say that anything good has come out of the credit crunch and mortgage mess, but it has created some unusual, if perverse, opportunities for fixed-income investors: Some municipal-bond funds are yielding more than Treasurys.

Historically that's not been the case, because munis are tax free. But thanks to uncertainty tied to an unnecessary product (we're talking municipal bond insurance), munis have taken a beating, making them compellingly cheap and high yielding for the little risk they carry.

The market forces that have crippled bond insurers Ambac (ABK) and MBIA (MBI) and mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) have hurt munis, too, but with little good reason. True, ratings agencies Moody's and S&P blew their calls on all that nutty securitized debt that got us into this mess, but historically munis have been rock solid. The odds of default on a top-rated muni are less than 0.01%. In other words, municipal bond insurance is, well, a racket.

That's so much the better for fixed-income investors. At a time when equities are sucking the yolks out of our nest eggs -- the S&P 500 is off a good 14% this year -- boring old municipal bond funds have more than maintained their value. The average return of the nearly 2,400 muni-bond funds tracked by Morningstar is 0.5% for the year to date.

Of course the big advantage of munis is the fact that they throw off tax-free income. Meanwhile, a provision in the housing bill signed by President Bush at the end of July has removed the alternative minimum tax from new issues of a type of housing muni. The upshot is that when we see high-rated, diversified, cheap muni bond funds yielding more than 4.5% (see chart), we like that risk/reward scenario.

The Vanguard Long-Term Tax-Exempt fund (VWLTX), for example, yielded 4.62% for the trailing 12 months. The expense ratio is a paltry 0.15%, there's no load and the minimum investment is just $3,000. (Sure, you could try to build your own portfolio of munis, but you'll probably need to commit at least a hundred grand -- most munis are sold in lots of $25,000.)

Now compare that to the Vanguard Long-Term U.S. Treasury (VUSTX) fund. There's no load, the initial investment is a friendly $3,000 and the trailing 12-month yield is 4.56%. But the expense ratio is higher, at 0.26%, and you'll have to factor in taxes.

Sometimes a good defense is the best offense. Munis offer tax-free income and they're low risk. The indiscriminate hammering of these boring bonds presents a rare opportunity.

Source: Morningstar