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Q

Net asset values of muni bond funds have dropped these days. I know I shouldn’t look at day-to- day market fluctuations, but with the $700 billion bailout coming, its potential drag on the economy and with bond insurers in trouble, I wonder if muni bonds or bond funds are still a good investment?

A

James A. Klotz responds:

Although observing the decline in the market value of your municipal bond funds can be unsettling, we believe current market conditions provide unusual opportunity in high quality tax-free bonds. Ironically, one of the reasons your market values are down is because nervous retail investors have been redeeming their bond-fund shares.

These redemptions force fund managers to sell municipal bonds into an illiquid market that is currently functioning without the support of large financial institutions, which are currently raising cash to support their own recapitalization efforts.

The combination of forced selling and the lack of market makers is responsible for pushing bond prices lower. The positive side of the coin, however, is municipal bond yields are at historically high levels and will provide unusual value for investors with the foresight to take advantage of this unique opportunity.

The government rescue plan to which you refer should have a positive impact on the bond insurers, who have been burdened by their exposure to risky mortgage bonds.

Today, quality municipal bonds can be purchased to yield approximately 6.00%, while taxable long-term Treasury bond yields are in the neighborhood of 4.50%. That 6.00% yield is comparable to earning over 9.00% for an investor in the 35% tax bracket, and will become more valuable as tax rates are hiked next year, as we are certain they will be.

We would not be surprised that, once again, investors with a longer-term horizon, who buy when the majority of people are inclined to sell, will be well rewarded when the smoke clears.