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In Defense of Muni Bond Funds

Dagen's recommendation draws some follow-up questions.

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

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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.

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

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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.