Catching the Wave of Municipal Bonds

It's been a puzzling summer for bond fund investors. The widely anticipated selloff in bonds somehow morphed into a rally, despite spiraling oil prices and a Fed chairman unwilling to see mixed economic data as anything more than a "soft patch" in the economy. Historically, under these conditions, rates should have spent the past three months rising, not falling.

The benchmark 10-year Treasury has traded around 4.25%, down from a June high of 4.88% and right back to where it was in April. But many strategists do not expect this low-rate reprieve to last and are steering clients out of Treasuries into tax-free municipal bonds before oil prices drop and the Fed hikes rates in September.

A municipal, or muni, bond is a debt security issued by a state, municipality or county in order to finance capital expenditures, such as bridges or sports stadiums. Municipals, as opposed to taxable bonds like Treasuries and corporates, are exempt from federal taxes and from most state and local taxes, especially if you live in the state the bond is issued, which is the essence of their attraction.

Munis' favorable tax implications make them a staple in the portfolios of baby boomers close to retirement and a must-have for people in high-income tax brackets, particularly those in states with high state and local taxes, such as New York. But analysts say a rising interest rate environment will increase the demand for munis, making them attractive to more than just the wealthiest investors.

Stagflation and the '70s

Analysts say the recent drop in rates will be fleeting because it runs counter to the traditional pattern. Just rewind your memory back to the 1970s and recall the stagflation -- low growth, high inflation -- caused by rising prices at the pump. And higher oil prices have historically led to higher interest rates.