The Nervous Rush to Munis

There's one good reason to buy municipal bonds now: You're not strong enough to stomach steep losses on stocks

Are you thinking of swapping some stocks for bonds? This is on a lot of people's minds. For the first time since 1998, municipal-bond funds are taking in more cash than investors are pulling out. Bob Santoro, a veteran Charles Schwab (SCH ) branch manager in Vero Beach, Fla., sees these kinds of moves up close. And he's suddenly noticing not just retirees, or people preparing to retire, but also fortysomething clients growing conservative amid the bear market. "There's this little thing in the back of their heads now: What if this lasts a lot longer?" he said.

Truly, there is no single, right answer to how much of your portfolio should be in stocks and how much in bonds. But if you're eager to lower your risk, I have two suggestions. First, get to the bottom of why you feel this way. Second, if you do find yourself in the market for bonds, shop thoughtfully.

Both are easier said than done. To be buying bonds now, when most yields are at lows not seen in years, implies one of three motivations. The first two--panic over money that has been lost on stocks or a belief that deep recession and yet lower yields lie ahead--strike me as foolish. No one trades wisely while panicking, and few people successfully predict interest rates. The third reason, a calm admission that you mistakenly saw yourself as strong enough to stomach steep losses on stocks, is the only one that makes sense.

If you're admitting that most basic mistake, then be careful as you look for bonds. Investors in the 28% or higher federal income-tax bracket (since July 1, the new rates run 27%, 30%, 35%, and 38.6%) have become used to seeing better aftertax yields on munis than on comparable corporate or Treasury bonds. But with high demand now pushing muni yields down, that rule is in flux, says Vanguard Group financial planner Jack Brod. Vanguard's intermediate-term muni fund pays 3.8%--the equivalent of 5.2% to investors in the 27% tax bracket. Its intermediate-term corporate bond fund now yields 6.1%. That's 4.5% after taxes for an investor in the 27% bracket.

As it happens, longer-term munis right now are offering the best balance of risk and return. The average yield on 30-year insured munis recently came to 96.5% of the 30-year Treasury bond's yield, while two-year munis yielded less than 88% of what two-year Treasuries paid. The sweet spot, according to Paul Disdier, Dreyfus' director of tax-exempt securities, is in the 13- to 15-year range, where investors get the most yield for the risk.

STEADY. Buying munis directly, though, is not for most people. Unless you have at least $500,000 to devote to your own muni portfolio, plus the patience to run it and reinvest the interest, you're better off using mutual funds. Closed-end funds can be a good choice when they trade at steep discounts, but that's not the case now. Thomas Herzfeld, a closed-end specialist in Miami, says he only gets tempted when they trade at discounts of 15% or more. "My guess is you won't see that until December," he said, when tax-related trades often cut prices.

That leaves the more familiar open-end mutual funds. With advice from Morningstar's chief bond-fund analyst, Eric Jacobson, I searched among the hundreds of muni funds (not counting those focused on a single state's bonds) for steady performers with low fees and no loads. I found four with portfolios full of longer-term bonds (table) worth considering.

One caution: As interest rates rise, long-term bonds fall more in price than do shorter maturities. If interest rates rise one percentage point, for example, these funds would lose about 8% in value, while comparable intermediate-term funds would sink 5% and short-term muni funds, 3%. And before you invest in any bond fund, remember first to examine why you are anxious to. If you are clear that the bear market has taught you something about yourself, don't forget the lesson whenever the bull does return.

By Robert Barker

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