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In Defense of Muni Bond Funds

Despite the attractive yields that municipal bonds are offering these days, some investors aren't convinced that these tax-exempt securities are solid investments.

Here's a little convincing.

Rick Capozza writes, "I am a recent subscriber to the Safe Save Plan and bought the (VWITX) Vanguard Intermediate-Term Tax-Exempt fund based on your suggestion. I have seen the fund drop the past few days and was wondering why, since interest rates have declined even further. Should I consider selling the fund?"

Whether you're talking about a bond or a stock fund, you've got to give an investment more than a few days to perform. Plus, you can't just watch the price of a bond fund. It pays interest, too. Its total return is what matters.

The price of the fund will rise and fall on the basis of what interest rates do. Generally, the longer the maturity on a bond, the more the price will fluctuate. When you buy a bond, you're agreeing to loan your money out for that period of time for a fixed rate. The longer the bond, the riskier that loan is. On a 10-year bond, you're essentially making a bet on where interest rates will be 10 years from now. You are locking in a rate on your money for a decade. If rates suddenly go up, your loan declines in value because newer 10-year loans pay more.

Focusing on shorter-term bonds or bond funds is a way to reduce that price volatility. Loaning money for one year at a certain rate is less painful than loaning money for 10 years if rates go up. But you also won't get paid as much interest on a short-term loan. And the income from even an intermediate-term municipal bond fund should be enough to offset the volatility you suffer because of interest rate moves.

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