Muni-Bond Bargains: Devil's in Details

If your stock portfolio has turned to sewage, maybe you should invest in a waste-treatment plant. Municipal bonds -- the tax-free securities issued by state and local authorities to fund such mundane projects -- are a once-in-a-lifetime bargain. Munis an Attractive Bargain for Investors Burned by the Market 3:26 WSJ's Intelligent Investor columnist Jason Zweig says municipal bonds are an attractive option for skittish investors. He tells colleague Nikki Waller munis are the cheapest they've been in at least 50 years, but that investors should be careful where they shop. For the first time in at least 50 years, munis offer much higher yields than Treasury bonds. That makes no sense, because the interest on municipals (unlike on Treasurys) is generally free of federal, state or local income tax. The tax exemption puts real money in your pocket. For an investor in the 33% federal tax bracket, longer-term munis are yielding almost 8% after tax, and even more if you live in an income-tax hell like California, New York or Oregon. Reid Smith, a portfolio manager at the Vanguard funds, points out that even if interest rates rise -- knocking down muni prices -- tax rates are also likely to go up. That would make the tax exemption on municipals even more valuable. Think about that 8% yield for a second. Since 1926, stocks have averaged a 9.6% annualized return, or only about 7% after tax. From today's yield levels, munis stand a good chance of outperforming stocks, after tax, in the long run. Unfortunately, despite its reputation for safety, the muni market is illiquid, fragmented and fraught with risk for the unwary investor. Last year, long-term national muni funds lost an average of 9.4% as the financial crisis battered the bond insurers that had enabled roughly half of all munis to be rated AAA. Ten funds, according to Morningstar, fell by at least 15% each -- a shocker in an investment category that has had a negative return in only four out of the past 25 years. What went wrong? Look at Eaton Vance National Municipals Fund, which lost 31.6% in 2008. Last March, the fund had $1.3 billion, or 23% of its net assets, in "tender option bonds." Spotting this exposure was no cinch: You had to read the semiannual report with a magnifying glass, circle each bond designated with footnote 1 ("inverse floating rate obligation"), then total all 27 of them. Although the fund was up to its armpits in tender-option bonds, who knew? Tender-option bonds are created when an investment bank takes the income from a muni and splits it into two pools of cash flow. The first is short-term and fixed-rate; the other, the tender-option part, is long-term and often highly variable. Last March, the Eaton Vance fund held a 30-year bond from the Virginia Housing Development Authority that was paying 17.518% and valued at $5.4 million; just six months later, the rate had dropped to 1.043% and the value to $2.6 million, a 52% loss. Robert MacIntosh, co-director of munis at Eaton Vance, says that the fund still holds this security and that tender-option yields have bounced back. "TOBs are part of our overall investment process," he says, "and we factor in the extra volatility associated with them in looking at the total portfolio." He adds, "They've been very positive performers over the years, and they have great tax-free income." But the whole point of municipal bonds is to provide tax-free fixed income. So you should steer clear of funds that rely on tender-option bonds and other yield shenanigans. Here are some red flags. First, download the fund's annual report, prospectus and "statement of additional information" in PDF format. Then use Acrobat's search function to look for keywords that may signal trouble, like "tender," "inverse" and "derivative." In the annual report, make sure the total investments in bonds don't exceed 100% of net assets by more than a percentage point or two. Insist on annual expenses of 0.5% or less, so the manager won't make risky bets to overcome the drag of high costs. Avoid any fund with portfolio turnover greater than 50%, a sign of excessive trading. Finally, Hugh McGuirk, head of the municipal team at T. Rowe Price, warns that bonds with interest rates that aren't multiples of 0.05 are likely to be tender-option bonds. Stick to funds from major firms with a sterling reputation, like T. Rowe Price Tax-Free Income or Vanguard Intermediate-Term Tax Exempt. If your brokerage has a free dividend-reinvestment program, then iShares S&P National Municipal Bond, an exchange-traded fund, is a solid choice. Whatever you do, don't chase the highest yields. To keep your muni money safe, stay out of the sewer. Write to Jason Zweig at intelligentinvestor@wsj.com