After one of the most spectacular runs in their history, it seems that the wheels are falling off the municipal bond train. Fears about the Fed’s tapering and rising interest rates, as well as some high profile city defaults have caused many investors to begin dumping the normally sleepy bond sector in spades. Outflows of popular muni funds- like the Market Vectors High-Yield Muni ETF (NYSE:HYD)–have been swift and several analysts have cautioned that more could be in store.

However, as investors have fled, the opportunity to score some pretty big bargains has finally emerged. There’s still plenty of reasons why a portfolio should include allocations to muni bonds. The recent sell-off could be a great opportunity to load up on the sector once again.

Weeks Of Outflows   

The normal staid and boring muni sector has been rocked by a series of events that have investors fleeing for the exits.

First, tapering fears have muni investors shaking about rising rates. The problem is that most municipal bonds are long dated- sometimes it takes 30 to 50 years for them to mature. As interest rates rise, bond prices fall and those bonds with a longer duration feel that hit harder than shorter ones. While no one can really guess when the Fed will start to taper its quantitative easing programs, that taper will come eventually.

Secondly, in recent months there have been a wave of large scale defaults from several municipalities. While the city of Detroit’s bankruptcy made headlines, other smaller cities have flowed suit- including cities in Pennsylvania, Alabama, Rhode Island and California. At the same time, downgrades and rising debt costs in Puerto Rico have also contributed to the nervousness.

These two main factors have caused 25 weeks of outflows from muni bond funds- averaging $722 million a week. 

Yet, there are still positives facing the sector- that includes high taxes for individuals. Tax reforms enacted at the end of 2012 will push the top income-tax rate to 39.6%. Additionally, the higher dividend tax of 20% and the new 3.8% Medicare tax on unearned income makes munis the place to be for higher earners. That fact should help support higher muni bond prices considering supplies of new bonds have been small. Even without this, our plodding along economy bodes well of bonds of all types- including munis.

Meanwhile, while the defaults have caught the public’s attention, they still represent such a small percentage of the total muni market. And even in those defaults, many bond holders received favorable resolutions. For example, Rhode Island passed a bill that gave bondholders a lien on property taxes to support its muni bonds in default.

Adding A Swath Of Sewer Bonds

Given that some of the nervousness in the sector may be unjustified, investors have the opportunity to re-up their exposure to the sector.

The easiest way can be through the immensely popular iShares S&P National AMT-Free Muni Bond ETF (NYSE:MUB). The fund spreads its $3.0 billion in assets around 2218 different municipal bonds and currently yields a tax-free 3.21%. Expenses are also cheap at 0.25%. For investors looking for a more active touch, the PIMCO Intermediate Muni Bond Strategy (NYSE:MUNI) could be used. The fund is currently focusing on "quality" versus yield and could be a good bet if the rally continues.

The only drawback to these two muni-superstars is their relatively long durations and sensitivity to interest rates when the Fed tapers. That means splitting an investment in them with the SPDR Barclays Capital Short Term Muni (NYSE:SHM) could be in order. The funds short term holdings will help cushion against rising interest rates. By pairing it with either MUB or MUNI, investors get a slightly higher yield and some interest rate protection.

Finally, there is plenty of ways for investors to add some “spice” to their muni positions. The new db X-trackers Municipal Infrastructure Revenue Bond Fund (NASDAQ:RVNU) focuses its holdings on bonds that supported by revenue from projects such as toll roads or bridges, while the Market Vectors CEF Municipal Income ETF (NASDAQ:XMPT) holds a portfolio of muni bond closed-ended funds. That focus on CEFs gives XMPT a hefty 6% tax-free yield. 

The Bottom Line

As interest rate/taper and default fears have taken hold, investors have fled muni bonds in spades. That outflow could be just what value hunters are looking for. There are plenty of positive reasons on why munis should still be in your portfolio. The previous picks might ideal ways to play the opportunity.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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