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Defensive Options for Muni-National Bond Investors

Things may get worse before they get better, but we think these funds are worth a look.

This year's credit meltdown has provided a pretty wild backdrop for muni-national bond funds. Bond prices have been hammered by a number of factors, including bond insurers' credit downgrades (or threats of downgrades) and muni hedge funds' en masse sales of their bond positions.

Even though interest rates are low, long-term funds have been hit the hardest: The typical fund in the category is down 4.9% for the year to date through Sept. 29, 2008. For that time frame, the typical intermediate-term fund is down 3.9% while the typical short-term offering has lost 1.6%. We'd note that much of the pain has come in the past two weeks, and it has been nearly a decade since any of the categories was in the red for a calendar year. (In 1999, the national intermediate-term category was down 2.1% while the national long-term category fell 4.7%.)

Amid all this bad news, we think there's a silver lining for muni investors. Falling bond prices mean that many managers are finding interesting opportunities. Plus, many muni-bond funds currently offer attractive taxable-equivalent yields even for investors in lower tax brackets. These fatter yields make it an even more interesting time to buy in. We'd add a word of warning, though. Given the extreme volatility and liquidity crunch in the muni markets recently, there is certainly the possibility that muni issues will continue to be punished in the near term. So, those who invest in these funds should make sure they have a long enough time horizon to withstand a few bumps in coming months.