Published: August 6, 2009

At the beginning of the year, panic-stricken municipal bond investors were fleeing for the exits. The muni market was roiled by fears that issuers would default and bond insurers couldn't make good on their guarantees. (They were right.) Bond prices plunged. Yields, which move in the opposite direction of prices, were the highest relative to Treasuries in a half-century.

Now that some time has passed, investors' fears appear to have been overblown. And as is often the case, what seemed like a crisis was really an opportunity. And bargains still abound.

Western Asset Municipal High Income Fund (NYSE: MHF), for example, had hovered at about $8 a share for the past decade. Then, last September, it began a steep plunge, hitting a low of $5.78 a share Oct. 6 and yielding an unprecedented 7.7%. Today, the yield has come down, but it's still a very rich 6.2%.

That may not sound like much, but there's a kicker. The income is tax-free.

You'd need to earn a 9.6% yield on an ordinary taxable bond fund -- assuming you're in the top 35% tax bracket -- to match the tax-free yield. As muni markets continue to rally, their prices are likely to rise, adding the potential of capital gains to a rich revenue stream.

$33,000 More Income
Most bond income is taxed at an investor's ordinary income tax rate. If you receive interest income of $5 a year from a corporate bond, you'll keep about $3.25 if you're taxed at the 35% federal rate. You'll pocket even less if you owe state or local taxes.

But municipal bonds are tax-free. When you buy a muni, you're lending money to a state or local government for public projects. The feds don't tax state-issued securities; states don't tax federal-issued securities. And if you live in the state or municipality where the bond proceeds are being used, the local government usually forgoes the taxes, too. So the tax-exemptions make muni yields far more attractive than you might think at first glance.

Consider two investment choices.

-- Multifamily Housing Revenue due Aug. 1, 2039, is a tax-free municipal bond issued by the California Housing Finance Agency. It carries an "AA" rating from Standard & Poor's and yields about 7.0%.

-- GE Capital's "Global MTN Series A due Jan. 10, 2039 is a corporate bond with an "AAA" rating from Standard & Poor's and selling today with a yield of about 7.8%.

The question: Which one would you spring for? After all, both bonds carry high-quality credit ratings and mature in 30 years, though the GE bond offers a higher yield.

Or does it?

Using a tax-equivalent yield calculator, you can see that the GE bond would need to yield 10.8% to match the yield on the tax-free California muni for an investor in the 35% bracket. The taxable equivalent yield is even higher if you live in California.

That yield difference adds up. Although the GE bond pays 7.8%, the after-tax yield is just 5.1% (also assuming the 35% tax rate). The after-tax income generated from a $100,000 investment would fall from $7,800 to $5,070. The California muni pays $7,000.

Munis are Safe
Municipal bonds have long been considered one of the safest investments around, and that reputation is well deserved. The average cumulative 10-year default rates for investment grade munis from 1970 to 2005 is just 0.07% versus 2.23% for equivalent corporate bonds, according to Moody's.

If safety is your top priority, general-obligation bonds are the ticket. These bonds are backed by the tax revenues of the governmental entity that issues them. These issues can raise taxes to repay the principal and interest if necessary.

Other munis, called revenue bonds or industrial-development bonds, are backed by the revenue streams of a specific project or facility. They offer higher yields, but there's more risk: The underlying revenue streams could dry up.

Last caveat: While most muni income is exempt from federal income taxes, a portion of the payout may be subject to the Alternative Minimum Tax. The AMT, as it's called, adds back certain tax-exempt items into the taxable income column. Funds that invest in higher-yielding munis issued by non-government agencies such as airports or housing agencies typically trigger the AMT for investors in the higher tax bracket. MHF's holdings aren't subject to the tax, but around 14% of the income earned by IMS's portfolio holdings is subject to AMT.

Good Investing!

-- Carla Pasternak
Editor
High-Yield Investing