These Mutual Funds May Keep Rallying

Tax-free mutual funds have been rallying.

National long-term municipal funds returned 8% during the past four months, according to Morningstar. That is a big change from 2008, when the funds lost 9.5% of their value.

Can municipal funds keep climbing? Yes. Fears of defaults, which plagued markets last year, should wane because of new support from Washington and changes in the market for municipal insurance.

For starters, the Obama administration's recovery plans should strengthen bond issuers. Before Obama was elected, municipal bond prices had been dropping partly because investors feared that the deepening recession could lead to defaults by states and cities. Then in late November, Obama began promising to pour money into states. Soon municipal prices began rising. The rally continued this year after the stimulus legislation provided $150 billion in direct aid for states. Recently, Rep. Barney Frank (D., Mass.) called for providing federal insurance for municipal bonds.

"There is growing support in Washington to make sure that the states stay afloat during the recession," says Andrew H. Friedman, a Washington attorney and consultant for Eaton Vance Investment Managers, a unit of fund manager Eaton Vance(EV Quote).

While assistance from Washington is pushing up bond prices, many issues remain at bargain levels. Yields on 10-year AAA-rated general obligation bonds, among the safest issues, are currently at 3.19%. That is the equivalent of a taxable bond yielding 4.43% for an investor in the 28% tax bracket. In comparison, 10-year Treasuries yield 3.17%.

Lower-rated municipals look like especially good values. To compensate investors for their additional risk, lower quality issues typically yield a bit more than the highest-rated bonds. From 1991 through late 2007, 10-year revenue bonds rated Baa, the lowest investment-grade rating awarded by Moody's, yielded about 70 basis points (0.70 percentage point) more than safe general obligation bonds carrying the top rating of Aaa. Then, with investors worried about defaults, the spread widened. It currently stands at 300 basis points, says George Strickland, a portfolio manager for Thornburg Investment Management.