Since the credit crisis began unfolding, many strange things have occurred in the fixed-income markets. Among the strangest has been the downturn of municipal bonds. High-grade municipals have long been considered reliable investments, but during the 12 months ending on October 27, the average long-term municipal fund lost 7.3 percent, while high-income municipal funds dropped 17.0 percent. It was one of the worst showings ever for tax-free bonds.

After the damage, municipals now represent an unusual bargain. “It is mind-boggling that municipal bonds can be this cheap,” says Tom Metzold, portfolio manager of Eaton Vance National Municipals.

At a time when corporate bonds and other fixed-income categories have collapsed, municipals may represent the best bargain available for cautious investors. After Treasuries, municipals rank as the safest choice. Many municipals are backed by the full taxing power of states and because of that security, defaults of AAA-rated general obligation municipals are virtually unknown. In contrast, investment-grade corporate bond default rates have been rising in 2008 (Leuthold Weeden research was forecasting a 5 percent default rate by year end versus the long-term average of 0.20 percent). The long-term default rate of high-yield debt averages about 4.4 percent per year; in the trailing 12 months that ended September 30, about 2.68 percent have defaulted.

Fearing A Spreading Flu

The descent of municipals was accelerated by a series of blows. The first problems began appearing in the summer of 2007. Worried about the credit crisis, investors dumped all kinds of bonds and raced to the safety of Treasuries. AAA-rated municipals fell along with below-investment-grade corporate securities.

Then the problems with bond insurers began to take a toll. A year ago, half of all municipals were insured. In a typical transaction, an A-rated municipality would buy insurance, raising the credit of bonds to AAA. By lifting the credit rating, the issuer could lower the cost of borrowing. Cracks in the insurance began to appear late in 2007. As home foreclosures increased, the insurers suffered losses in their coverage of mortgage securities. In January 2008, the rating of a big bond insurer, Ambac, was reduced from AAA to AA. Instantly, the prices of $500 billion worth of municipal bonds dropped as investors questioned the value of the insurance.

Bond prices had begun to stabilize when municipals suffered another blow — trouble at Lehman Brothers and other investment banks. The big investment banks had long traded municipals and held sizable inventories of bonds. As these major buyers left the market, prices again slumped in September.

To appreciate how cheap municipals have become, compare them to Treasuries. Because of their tax advantage, the yield of municipals is typically about 85 percent of the Treasury yield. That is where the market stood in May 2007 when 10-year investment-grade munis yielded 4.0 percent, compared to 4.8 percent for comparable Treasuries.

Then things turned peculiar. With investors dumping municipals, their prices fell and yields rose to 4.7 percent. Meanwhile, Treasuries soared, and their yields dropped to 3.8 percent. At that level, the yields of municipals were 123 percent of Treasuries, nearly an all-time record. The municipal yield was the equivalent of a taxable bond yielding 7.2 percent for investors in the 35 percent bracket.

A Changed Market?

In the past, many clients preferred buying individual municipals and holding them to maturity. But in today's rocky market, finding the right bonds can be difficult. Few new issues are coming to market, and investors who seek to sell a bond may find few takers. To avoid these concerns, clients may be better served by sticking with mutual funds because even in the current crisis, funds remain easy to buy and sell.

Investors seeking safety should consider Vanguard Intermediate-Term Tax Exempt, which has more than 90 percent of its assets in bonds rated AA or AAA. The fund avoids making risky bets on interest rates or market sectors. “We always play down the middle of the fairway,” says portfolio manager Reid Smith.

Despite the cautious approach, the tax-exempt fund has outdone 83 percent of its competitors during the past decade, according to Morningstar. Vanguard manages this feat by charging its customary low fees. Because expenses are subtracted directly from yields, cheaper funds tend to have higher yields and better returns. While Vanguard's fee policy provides an advantage for all its funds, the low costs are particularly important for municipal funds, which have modest yields compared to taxable bonds.

While the average intermediate municipal fund has an expense ratio of 0.93 percent, Vanguard charges only 0.15 percent. The low expense ratio explains why Vanguard yields half a percentage point more than its average competitor — even though many competitors hold riskier bonds.

Another cautious choice is Fidelity Intermediate Municipal, which has outdone 93 percent of its competitors during the past decade. Like Vanguard, Fidelity avoids big bets. The fund makes a series of small moves instead, seeking bonds that are likely to benefit from credit upgrades. While portfolio manager Mark Sommer keeps the duration of the portfolio steady, he changes the mix of maturities. Currently the fund is light on intermediate bonds; Sommer is emphasizing short-term bonds and longer-term issues. “Bonds with 15-year maturities are cheap now, and yield much more than shorter bonds,” he says.

When interest rates rise, long-term bonds tend to suffer particularly big losses. That happened to municipals in the past year. But when muni yields drop again, long bonds will likely record big gains. To play the rebound, consider Eaton Vance National Municipals, which specializes in long bonds. Portfolio manager Tom Metzold buys bonds with maturities of 20 years or longer. At a time when long bonds are paying relatively richer yields, the fund yields 5.2 percent.

Though Eaton Vance suffered in the market downturn, Metzold is not changing his strategy. “Long bonds represent some of the best values in the marketplace now,” he says.

To take a bit more risk (and potentially, reward), consider MFS Municipal Income. While the fund often has an average credit quality of AA, portfolio manager Geoffrey Schecter is willing to buy some riskier issues when they seem like bargains. Currently the fund has 15 percent of assets in bonds rated BBB, the lowest rung in the investment-grade category. Another 5 percent of assets are below-investment-grade.

A year ago, the fund had little exposure to below-investment-grade issues. At the time, there was only a small spread between the yields on high-grade and low-quality issues. Schecter felt that there was little incentive to take on the extra risk of low-quality issues. But in the volatile markets, prices of low-quality issues have been punished severely, and that has created some bargains. “We are moving into lower-quality issues because they are generating high levels of income without presenting excessive risk,” says Schecter.

Clients who can tolerate risk should try MFS Municipal High Income. The fund has 45 percent of assets in bonds that are unrated or rated below-investment-grade. The shakier credits enable the fund to yield 5.8 percent — that is a rich payout. And when municipals finally revive, the MFS fund could deliver healthy capital gains.

MUNICIPAL UPRISING

Funds that will thrive when municipals rebound.

Fund Ticker Category Three-year Return Five-year % Return Category Rank Five-Year Return Maximum Front-End Load
Eaton Vance National Municipal AEANAX Muni Long 0.9% 4.6% 4% 4.75%
Fidelity Intermediate Municipal FLTMX Muni Intermediate 3.5 4.1 6 0
MFS Municipal High Income A MMHYX High-Yield Muni 1.9 4.6 14 4.75
MFS Municipal Income A MFIAX Muni Long 2.8 4.4 6 4.75
Vanguard Intermediate Tax Exempt VWITX Muni Intermediate 3.4 3.8 19 0
Source: Morningstar. Returns through 8/31/08.