Opportunity in Long Term Municipal Bonds

Municipal bond funds are attractive investment vehicles for high tax bracket investors. These bonds invest in debt issued by cities and other municipalities. They usually offer lower, steady returns, but are tax-free. However, in recent weeks, Muni bond prices have fallen pushing yields higher, as investors moved money into the safer securities, such as short-term Treasury bonds.

In the muni-bond market, the yield curve is usually steeper than for Treasury bonds or corporate debt. That's partly because cities and states like to borrow money for long periods, while mutual funds prefer to buy shorter-term muni bonds. That means there's lots of supply of longer-term muni bonds, so issuers have to offer higher yields to sell them. Some hedge funds use this to their advantage by buying the higher yielding, long-term muni bonds and then chopping up those into short-term munis called tender option bonds (TOB) and selling those to other investors with lower yields. So the hedge fund ends up making money on the difference between long-term and short-term muni yields. Such trends had led to flattening of the muni yield curve but the market turmoil in August originating from sub-prome mortgages again pushed the yield for long-term muni bond higher.

After sharp losses in August, most mutual funds based on municipal bonds remain down by 5% or more so far this year. These include the $4.6 billion Eaton Vance National Muni fund (EANAX, Friday's close : 11.20, +0.02), the $5 billion Oppenheimer Rochester National Muni fund (ORNAX, Froday's close: 11.65, +0.01, down about 8.5% this year), the Goldman Sachs High Yield Muni fund (GHYIX, Friday's close: 10.71, +0.02), the Nuveen High Yield Municipal fund (NHMAX, Friday's close: 21.34, +0.03).

This downturn has presented opportunities for individual investors. Some investors may now give a serious look at such funds to take advantage of the current high yield of longer-term muni bonds.