In Defense of Muni Bond Funds

This Vanguard fund is currently sporting a yield that's above what its comparable Treasury fund is offering. Plus, you will not pay federal taxes on that income.

Yes, this fund can lose money if rates jump dramatically. But you won't lose nearly as much as you would in stocks. This Vanguard fund has lost money in just two out of the last 10 years. And the biggest loss it suffered was a decline of a paltry 2%. That's not enough to scare you away.

Steve Daiboch sent in the following email: "I don't understand how it is 'saving safe' to invest in a municipal bond fund when interest rates are at all-time lows. Isn't there a high risk of capital loss? I had a position in (VNJTX Quote)Vanguard Long-Term NJ Tax-Exempt fund and sold it for this reason. Of course, its net asset value is higher now, and my proceeds are languishing in a money market. Is it safe to buy individual short- or intermediate-term bonds if you are willing to hold them to maturity?

Municipal bonds are a lot safer than, say, corporate debt, when it comes to default risk. That's simply the chance that the issuer of a bond won't be able to pay the interest and return your principal on that bond.

Part of that goes to the faith and credit of the borrowing entity. Treasuries are the least risky bonds because they're backed by the full faith and credit of the U.S. government. Local governments aren't quite that secure. But they do have one major advantage over corporations. A state or municipality can raise taxes to pay off their bonds. A corporation cannot easily raise prices to do the same.

And so-called revenue bonds, which are issued to finance public works projects such as water systems, are supported by the money brought in from those services. And everybody needs water.

As for buying individual bonds, you can't beat the diversification you get in a mutual fund. "Any adverse situation on a credit will have minimal impact on the overall portfolio," says Hugh McGuirk, a tax-exempt manager at T. Rowe Price. "A fund can do that because it can spread its money around to 1% to 2% positions."

On your own you'd be hard-pressed to get that kind of diversification.