(FORTUNE Magazine) – Two wallflowers at the long-running bull market bash are suddenly turning heads: balanced mutual funds and municipal bonds. Both are benefiting as nervous equity investors move money into fixed-income investments.

With balanced funds, which invest in both stocks and bonds, bond income can cushion the blows of a volatile stock market. For example, while the S&P 500 stock index plummeted 9.9% in the third quarter, balanced funds were off just 6.4%, according to Lipper Analytical Services.

Municipal bonds, too, have fared better than many other investments. Prices have climbed, though not as fast as those of soaring Treasury bonds--the ultimate safe haven. (Another reason is that a near-record supply of muni issues swamped the market, while issuance of Treasuries, which appeal to a wider, international audience, continued to slow.) All this has created an unusual bargain: Long-term, AAA-rated munis, which are tax-free, now yield a historically high 96% of comparable Treasuries, which are taxable at the federal level. That means that munis, after taxes, are yielding much more than Treasuries.

Now comes a study, published in this fall's Journal of Investing, suggesting that, for taxable accounts, a balanced portfolio of stocks and munis beats the traditional balanced-fund mix of stocks and taxable bonds. The study's authors: Donald Peters and Mary Miller, co-managers of the T. Rowe Price Tax-Efficient Balanced fund, a blend of growth stocks and muni bonds. No coincidence, that.

Using data from Morningstar, Peters and Miller studied the returns, tax efficiency, and risk characteristics of four types of funds over ten and 20 years: growth, growth and income, muni bond, and taxable bond. For anyone at or above the 28% tax bracket, growth funds had higher pretax and after-tax returns than growth and income funds, the typical equity component of a traditional balanced fund. Muni bond funds had lower pretax returns but higher after-tax returns than taxable bond funds.

Of all the portfolios, muni funds and growth funds had the highest "tax-efficiency," or after-tax return as a percentage of pretax return. They also were more volatile than their counterparts, however, meaning that their returns ranged more widely year to year. This makes sense: Growth funds lack the ballast of income-producing stocks, the very trait that keeps their taxes down; munis have longer maturities than taxable bonds, on average, so their prices are more sensitive to interest rate swings.

Next, Peters and Miller married the growth and muni bond portfolios fifty-fifty, and compared the results with the traditional balanced-fund mix of 60% growth and income stocks, 40% taxable bonds. (By law the growth-muni combo must maintain at least 50% of its assets in munis for investors to reap the tax benefits.)

The smaller equity stake in the growth-muni mix hurt the fifty-fifty combo's pretax performance. Its average annual pretax return for the 20 years through 1997 was 11.9%, vs. 12.8% for the traditional mix, for investors in the top tax bracket. After taxes, though, the growth-muni blend pulled ahead, 10.1% to 8.8%. Thus, a traditional balanced fund remains the better choice for tax-deferred accounts, such as IRAs, but a mix of growth stocks and munis is better for taxable accounts.

The growth-muni mix was more volatile than the traditional balanced blend, but not as volatile as the stand-alone growth and muni portfolios. For example, the growth-muni portfolio achieved 77% of the growth portfolio's after-tax return, but with only 70% of the volatility. One reason: Munis and stocks perform fairly independently, so losses from one can offset gains from the other--a valuable tool in any taxable account. In marketspeak, the "correlation" between the two over the past five years was just 0.39. (A 1.00 would imply the two move in lock step.)

You could build your own tax-efficient balanced fund by splitting your money between a good muni-bond fund and a good growth-stock fund. If you prefer a ready-made fund, there are a handful of no-loads to choose from (see table). Most use growth stocks of some kind on the equity side. Since its launch in June 1997, T. Rowe's fund, the newest of the lot, has had the best returns.

"I think of it as an important building block for taxable investors," says co-manager Donald Peters, who handles the fund's equity side. Peters says he's invested part of his children's college money in the fund. "Since they're all under 14, they're paying my tax rates, so tax efficiency is very important," he says.

With $136,000 in net realized losses on their books, Peters and Miller don't expect to make a capital gains distribution this year. And they dismiss the notion that a fund must have low turnover to be tax-efficient. "Our turnover should be less than 10% in a rising market," says Miller, "but in a falling market it makes sense for us to harvest losses."

There will be a dividend distribution in the fourth quarter but, because the fund eschews high-dividend stocks, its equity portfolio has a lower dividend yield than the S&P 500--1.1% vs. 1.6%--thus minimizing taxable income for investors.

Despite its smaller complement of stocks, Tax-Efficient Balanced has outperformed the average balanced fund and the S&P 500 in the past year, returning 9.9% pretax, vs. 3.3% for balanced funds, and 9.1% for the S&P. And in August, when the S&P slid 14.4%, the equity side of the portfolio went down 15%, but the fund as a whole fell just 6.5%, compared with an average 8.7% drop for balanced funds.

Not bad for a couple of wallflowers.