Municipal bonds - dubbed "munis" by aficionados - are the comeback kids of the fixed income world.
Little wonder: "Municipal bonds are now historically cheap relative to US Treasury bonds," says John Holliday, manager of the United Municipal Bond Fund, part of the Waddell & Reed Group, in Overland Park, Kan.
The fund, which charges an up-front commission of just over 4 percent, has returned 5.37 percent in 1998 through Sept. 30, far better than most equity funds, and exceeding returns for many long-term Treasury bond funds.
Any investor in the 28 percent or higher tax bracket should consider buying municipal bonds now, says Mr. Holliday.
Conservative investors, who typically tend to be bond-fund investors, often opt for US Treasury issues, given their relative safety and exemption from state and local taxes.
But solid performance combined with tax advantages mean "municipal bond funds can do as well or better" over time, Holliday says.
You pay no federal tax on interest income from munis. They are also, in many cases, free from state and local taxes.
This "double exemption" means an investment whammy for people in higher tax brackets, says Monte Avery, who manages a number of single-state muni funds under the Integrity Group and Ranson Group labels in Minot, N.D.
And while Treasury-bond prices have soared in recent months, muni prices have stayed relatively stable, making them a comparative bargain, Avery says.
The market for muni bonds, which are issued by state and local governments, has been battered by reports of corruption and personal manipulation. Some high-profile defaults, including the debacle in Orange County, Calif., also scared away investors.
But the sheer size of the market, $1.4 trillion, as well as the independent safety ratings on muni bonds, makes it more stable than its recent reputation suggests.
For the average investor, the best way to buy municipal bonds is through mutual funds, says Mr. Avery,
Yields on the bonds are "running at 95 percent to 100 percent of 30-year Treasury bonds," he says.
Buying individual bond issues is best left to sophisticated investors, most experts agree. Muni bonds can be difficult to understand, are riskier than Treasuries, and no organized marketplace or exchange exists for them.
Bonds are sold through more than 2,500 brokerage houses and banks, with wide variations in price and availability.
Instead, turn to one of the scores of muni-bond mutual funds, tracked by reporting services such as Morningstar and Value Line.
"For average investors, you can't go too wrong investing with a well-established bond fund in a group such as Fidelity, USAA, T. Rowe Price, or Vanguard," says Alice Lowenstein, who tracks municipal bonds for Morningstar in Chicago.
Her preferences include:
* USAA Tax Exempt Long-Term. Up 5.52 percent through Oct. 20; $3,000 minimum investment. 800-382-8722.
* T. Rowe Price Tax-Free Income Fund. Up 5.99 percent through Sept. 30; $2,500 minimum investment. 800-638-5660.
* Vanguard Muni Long-Term Fund. Up 5.69 percent through Oct. 15; $3,000 minimum investment. 800-662-7447.
Muni funds are "very attractive," says Ms. Lowenstein. They can not only provide solid returns, but also offer much more diversification - more safety and higher returns - than specific bonds or a strict focus on stock funds.
She recommends funds with bonds rated A or better, but she also likes funds that include up to 10 percent of their portfolio in lower rated, higher-yielding issues. That mixture helps boost returns without excessive risk.
Since muni bonds are already tax sheltered, these funds don't make much sense for a tax-deferred account, such as a 401(k) or 403(b) retirement plans or an IRA.
* Quality is crucial. Low-rated bonds have a greater risk of failure. So look for funds that carry the highest rankings from Morningstar or Value Line. And look for funds that that carry high-rated bonds of A or above. Triple A (AAA) is best. A good fund, however, will include some low-rated bonds. That boosts the return without too much risk.
* Invest for the long term. Changes in interest rates can lead to short-term market turbulence. When interest rates go up, bond prices go down and vice versa. So watching the daily price fluctuations of a bond fund can be unsettling. But bonds and bond funds are not short-term investments. Their purpose is usually to provide steady income and to preserve your money.
* Consider the tax consequences. Single-state bond funds - those that buy only one state's bonds - give investors who live in that state a double tax exemption - free from both state and federal taxes. This works best for investors in high tax brackets.
* Watch out for fees. Funds offered by big investment companies - such as Fidelity, Vanguard, Pemco, Strong - usually charge the lowest fees. Look for management fees below 1 percent.