Munis: The new power portfolio

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(Money Magazine) -- If there's a lesson to be learned from the stock market's recent slide - triggered by massive losses on exotic and risky mortgage-backed securities - it's that there's nothing wrong with simple, boring investments. Like girders supporting a bridge, plain-vanilla bonds can help buttress a portfolio in a shaky market such as this.

Well, you can't get more basic than municipal bonds. And because the yields on munis have not fallen as sharply during this subprime crisis as those on Treasuries, most munis are paying out more than comparable bonds issued by Uncle Sam. And that's despite the fact that income from municipal bonds is largely exempt from federal income taxes. Income from Treasuries is not.

Typically, munis, which are issued by cities, counties and states to finance the construction of roads, bridges and other public works, pay out about 20% less than Treasuries. This keeps the two roughly in line after taxes (muni income is often also state-tax-free for investors who own securities issued within their home state).

But in January, high-quality five-year munis - those rated triple A by agencies like Standard & Poor's or Moody's - were paying out 2.80% on average, according to Municipal Market Advisors. That was notably higher than the 2.53% yields of five-year Treasuries. Yes, rates are still modest in absolute terms. But "it's been very rare that you can buy a true triple-A-rated muni bond at 100% of Treasuries," says George Strickland, managing director of Thornburg Investment Management.

Keep in mind that if you're in the 28% tax bracket, a 2.80% yield on a muni is really the equivalent of a 3.89% yield on a comparable Treasury. (To figure this out, subtract your tax rate, or 0.28, from 1, which gives you 0.72. Then divide the muni yield by that figure.) The bottom line: Investors in the 28% bracket can now pocket 54% more income holding bonds issued by cities than they can investing with Uncle Sam. If you're in the 35% bracket, you'll earn 70% more after taxes.

One could argue that this is only to be expected in a recession-bound economy. After all, Treasuries are the safest investments around. If push comes to shove, the federal government can print money to cover its debts. Municipalities can't do that, which means a city could conceivably have a hard time paying as promised.

But that risk is tiny. The average default rate on a triple-A-rated muni has been less than 0.01%. And that risk shrinks further when munis are held in a diversified portfolio. "As in any market, you need to be selective about what you buy," says Steven Shachat, a portfolio manager with the Alpine Mutual Funds. "But munis have had a basically zero-default rate, and we don't expect that to change anytime soon."

The last time munis outyielded Treasuries was at the end of 2002, another period of great uncertainty. Back then Wall Street was in the final throes of a bear market. And growing talk of a war in Iraq sent investors flooding into Treasuries, driving down their yields relative to munis. Had you taken advantage of that buying opportunity, your tax-free portfolio would have beaten government funds that invest in intermediate-term Treasuries. And that's before the tax benefit. Moreover, munis outperformed during this stretch despite a disappointing 2007.

The municipal bond market took it on the chin in 2007, largely due to the performance of lower-rated munis. Though tax-free bonds in general yielded more than 3% last year, a late-year sell-off pushed down muni prices. This explains why on a total-return basis - which factors in a bond's yield plus or minus changes in the underlying security's price - muni bond funds returned only 1.6% last year.

You can blame that on outside factors, like the credit crunch created by the subprime mortgage mess. For instance, several firms that insure municipal bonds have come under pressure lately - not because of troubles in their muni business, but because of losses on mortgage-backed debt that these insurers also guarantee. While this could affect muni prices in the short term, in the long run it's not likely to hurt the ability of cities to make good on their obligations.

Municipalities "have the power of taxation, and nobody's turning out the lights anytime soon," says Shachat. And things can't be all bad: Warren Buffett just entered the bond insurance business.

Market watchers say this window of opportunity for munis won't last forever. In fact, they don't expect munis to continue to outyield Treasuries past this year.

To make a move into munis, you have three basic options: individual bonds, mutual funds and exchange-traded funds. In the past it was difficult for investors to buy munis on their own because it was hard to get pricing information on individual securities. That's begun to change. You can now go to sites like Investinginbonds.com to find current prices and yields.

Still, there are some challenges in constructing a portfolio of individual securities. Since these bonds are typically sold in large blocks, you might not get a decent price if you're investing a small amount. And it might take $250,000 to build a diversified portfolio. So a fund may be a better option.

Muni funds: If you live in a state that exempts local munis from state income taxes, such as New York or California, your best bet is to start with low-cost funds that invest only in your home-state bonds. For California residents, Morningstar muni analyst Scott Berry recommends Fidelity California Municipal Income (FCTFX).

If you live in a state that doesn't exempt local muni income, like Iowa or Illinois, a better option would be an intermediate-term national muni fund, which provides geographical diversification. Your best bet: Vanguard Intermediate-Term Tax-Exempt (VWITX), which has an annual expense ratio of just 0.17% and is in the Money 70, our list of recommended funds.

Whether you go with an in-state or national fund, bond strategists suggest sticking with intermediate-term portfolios. Right now it doesn't pay to commit to long-term bonds, which aren't yielding much more than intermediates but are more volatile in price.

Muni ETFs: Over the past year, several firms, including Barclays Global Investors, PowerShares and State Street Global Advisors, have launched ETFs that invest in munis. But Marilyn Cohen, president of bond management firm Envision Capital, says investors should proceed cautiously. Though these ETFs mimic established benchmarks such as the S&P National Municipal Bond index, it's unclear how well they can track these indexes.

"These ETFs are not seasoned yet," she says. Still, she's optimistic about municipal bonds in general, and not just because of today's market opportunity. Cohen believes, with some justification, that tax rates are likely to rise in the future. "Federal tax rates are only going up," she says. And any munis bought at today's tax rates "are going to look fantastic down the road."

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