Muni Bonds: Time to Dive In?

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Going Further Out

There are also new openings in longer-dated maturities. Before last year's sell-off, Putnam's muni funds had been weighted toward bonds set to mature in 15 to 20 years, due to the extreme flatness in the muni yield curve. But the yield curve has since gotten steeper—to the point that investors now get more yield for longer maturities—which has prompted Meehan and her fellow fund managers to move more into 20- to 25-year bonds.

John Miller, chief investment officer at Nuveen Investments in Chicago, also sees the cheapest prices for the longer-dated bonds and predicts they will appreciate in price over time as inflationary pressures ease over the longer term, reducing the steepness in the yield curve.

Ironically, insured bonds can also be bought at added discounts now that bond insurance has fallen so far out of favor since the rating downgrades. This month, just 8% of newly issued bonds carried insurance, compared with 25% during the first half of 2008 and roughly 50% in prior years, according to Ying at JPMorgan.

Look at the Schools

The elimination of the automatic stamp of approval that bond insurance once represented means investors buying individual issues need to do much more work to assess issuers' underlying creditworthiness and grasp the risks. For lesser-known cities and towns, the profiles of local school districts, typically available on the Web, can be a great tool, says Bill Larkin, a fixed-income portfolio manager at Cabot Money Management in Salem, Mass. Checking the success rates of schools, how many students go on to college, as well as how high income levels are in the community and whether school districts have had any funding problems, can tell you a lot about how much credit risk you may be taking on.

"I don't want to [invest] in a place that has been devastated by plant closures for auto parts," he says, adding that he prefers localities with economic opportunities.

Yields are much higher on single-A and double-A muni bonds issued to finance essential services, such as toll roads and bridges, than they were in the past—around 4.5%, in some cases, as opposed to 3.5% two years ago, Larkin says.

Questions about how long the U.S. economic slowdown will last also make bonds for essential services and electric utilities a safer bet, as their revenue streams are steadier and less susceptible to economic fluctuations, says Nuveen's Miller.

Let Funds Do the Research

The economic uncertainty associated with mortgage defaults and lower home values makes this an especially good time to diversify with muni bond mutual funds and exchange-traded funds, say strategists. And the additional due diligence required in the absence of trustworthy insurance guarantees also argues in favor of mutual funds, which have the staff and expertise for that kind of work.

Mutual funds are particularly advisable for investors interested in bonds rated double-B and below, since, besides good yields and diversification, they offer the liquidity that single issues, especially below investment grade, don't, says Larkin at Cabot.

Another plus for bargain-hunting investors: As rating agencies recalibrate their rating scales, one result could be a number of rating upgrades. The agencies have been under pressure to apply the same global rating standards to U.S. munis that they use for corporate, sovereign, and other types of bonds. Those changes, which have the potential to boost ratings on many muni issues, have not yet been incorporated into muni bond prices, says Miller at Nuveen.

In a July 31 draft proposal of its new rating scale, Fitch Ratings said that after the recalibration, the percentage of state and local general obligation credits in the double-A and triple-A categories is expected to rise to about 86%, from 58%. That will give hedge funds and commercial banks a much bigger basket of issues to choose from in building up their portfolios, and it will enhance overall liquidity in the market—one more reason for individuals to give munis a closer look.

Bogoslaw is a reporter for BusinessWeek's Investing channel.