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Investing Specialists

Is It Time to Buy American's Muni-Bond Funds?

These funds pack plenty of appeal right now.

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This month, I'm taking a look at a small corner of the American Funds lineup: Its municipal bond funds. Although these five funds-- Tax-Exempt Bond (AFTEX),  High-Income Municipal Bond (AMHIX),  Tax-Exempt Fund of California  (TAFTX), Tax-Exempt Fund of Maryland (TMMDX), and Tax-Exempt Fund of Virginia (TFVAX)--comprise just 1% of American Funds' assets among them, they deserve attention from investors looking for bond funds in their taxable accounts. Not only do these funds have substantial, fundamental merits (more on that below), but they represent potential buying opportunities right now.

Muni bonds had a subpar year in 2007. As subprime mortgages imploded, a liquidity crunch ensued. Also, hedge funds and others that had made leveraged bets on muni bonds and then hedged those bets by shorting Treasuries, got stuck when Treasury bonds' prices rose as investors fled to "quality" in the wake of the credit crunch. To cover their shorts, the funds sold some of their muni-bond holdings, thus driving those bonds' prices down and their yields up. Also, investors became concerned about the potential for declining tax revenues from housing and the financial health of bond insurers (a number of muni bonds are insured). As a result, the typical muni national intermediate-term fund (the most common type) gained just 2.7% in 2007. And they haven't looked any better in 2008: For the year to date through Feb. 12, the typical fund in that category has gained only 0.29%.

Perhaps more importantly, yields for higher-rated muni bonds now rival those of high-rated taxable bonds. That means munis are currently a better deal in a taxable account than taxable bonds--even for investors in low tax brackets. That's rather unusual. For example, the 10-year Treasury bond sported a yield of 3.5% as of Feb. 12, 2008--slightly lower than the 3.61% yield of a 10-year AAA rated municipal bond. An investor in, say, the 28% tax bracket would earn a tax-equivalent yield of 5.01% on a 10-year muni bond.

Greg Carlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.