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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) - Get Vanguard Interm-Term Tax-Exempt Inv Report


Fidelity Intermediate Municipal Income

(FLTMX) - Get Fidelity Intermediate Muni Income Report

. An intriguing new fund for today's difficult environment is the

Thornburg Strategic Municipal Income

(TSSAX) - Get Thornburg Strategic Muni Income A Report

, 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.

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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.

ETFs also provide diversification, but they present risks that were highlighted in the November downturn. The ETFs own baskets of securities and trade constantly on stock exchanges. Most often, the share prices trade for the value of the assets in the portfolios. But in uncertain times, the shares can dip and sell for a discount to the value of assets.

During the week of November 15, discounts reached 2% for ETFs such as

iShares S&P National AMT-Free Muni Bond

(MUB) - Get iShares National Muni Bond ETF Report


SPDR Nuveen Barclays Capital Municipal Bond

(TFI) - Get SPDR Nuveen Bloomberg Municipal Bond ETF Report

. Investors who sought to sell would have only received 98 cents for every dollar of assets in the portfolio. In contrast, mutual funds always trade for 100 cents on the dollar.

To further the case for buying a municipal mutual fund, municipals represent some of the most attractive fixed-income values, with 10-year tax-free issues yielding 3.10%. That is the equivalent of taxable bonds with yields of 4.3% for investors in the 28% bracket. In contrast, 10-year Treasuries yield only 2.8%.

The Thornburg Strategic Municipal Income fund has the flexibility to roam throughout the bond universe, buying issues of different maturities and credit qualities. This is very different than typical funds, which focus on a single segment, such as long-term high-quality bonds. "We wanted to offer a fund that can take advantage of the changes in municipal markets," says portfolio manager Christopher Ryon.

A year ago, the Thornburg fund began emphasizing bonds rated BBB, the lowest category in the investment-grade universe. The managers figured that the bonds had become undervalued as investors worried about defaults. Thornburg also emphasized longer bonds; they thrive when interest rates fall. The strategy proved on target. During the past year, the fund returned 6.5%, outdoing 98% of its peers.

The greatest long-term danger faced by municipal investors now could be a rise in interest rates. If that happens, bond prices will fall. But Thornburg has the ability to limit interest-rate risk by focusing on short-term bonds. Such bonds can prove relatively resilient in periods of rising rates. By exploiting its flexible mandate, the Thornburg fund may be able to protect shareholders against the hazards of volatile municipal markets.

-- Written by Stan Luxenberg


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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.