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Why Muni Funds Beat Bonds, ETFs

A storm swept through municipal markets in November. National municipal long-term funds lost 2.7% for the month, according to Morningstar. Panicked shareholders dumped funds, withdrawing $4.7 billion in the week of November 17 alone, according to the Investment Company Institute.

Is the worst over? Probably. Municipals fell when a flood of new bonds from California and elsewhere swamped demand. In recent days, the market has recovered as the level of new supplies slowed.

While the November downturn may have been a temporary blip, the turmoil is worth considering because it highlights the strengths of old-fashioned mutual funds.

At a time when changes are sweeping through tax-free markets, most investors who want to hold municipals should own them through mutual funds.

Should you buy a municipal mutual fund now? Yes. Top fund choices include Vanguard Intermediate-Term Tax-Exempt (VWITX) and Fidelity Intermediate Municipal Income (FLTMX). An intriguing new fund for today's difficult environment is the Thornburg Strategic Municipal Income (TSSAX), which has a yield of 4.1%.

Those who elect to hold individual bonds or municipal ETFs will face new hazards.

Shopping for individual bonds can be especially risky. In the past, selecting individual bonds was relatively simple, and markets were homogenous. Half of all bonds carried AAA ratings because they were insured. Default rates were negligible. If an insured bond did default, insurance companies nearly always made good on the loss. That simple world ended in 2008 when most bond insurers suffered big losses in mortgage markets. Some insurers left the business, and now only 7% of bonds are insured.

Regardless of whether a bond is insured, it has become more difficult to size up the outlook. In the past, most high-quality bonds traded in unison. If prices of Treasuries climbed, municipals also rose. But these days, markets can deliver surprises as investors worry about the difficult outlook for states and other municipal issuers. When a state like California faces a budget crisis, the bonds can soften -- even during periods when Treasury bonds are rising.

In this uncertain territory, municipal mutual funds offer some security. The funds are run by professional portfolio managers who can monitor the daily shifts in credit conditions and pick the safest bonds. Few individuals have the time or inclination to do complicated research and stay abreast of changing markets.

In addition, mutual funds offer some protection by staying broadly diversified. A typical fund owns hundreds of securities. If one or two default, then the portfolio will not suffer much. Also, because bonds cost $10,000 or more, most individuals cannot afford to build broadly diversified portfolios of individual securities.

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