Time for Municipal Bonds?

Investing in sewage-treatment plants and highway overpasses isn’t always this consistently lucrative. Municipal bonds have posted gains for 10 consecutive months, the longest rally in state and local government debt since 1992. Munis, which have a reputation for stability and safety, have returned 8.1% this year, through Thursday, including both price gains and interest payments. That tops the 4.1% return for ultrasafe U.S. Treasurys as well as the 6.4% for highly rated corporate bonds and 4.5% for so-called junk bonds, both of which are seen as riskier investments. Munis aren’t far behind blue-chip stocks.

That’s not all. Muni investors typically pay no federal tax on the interest—and if they live in the state or city that issued the bonds, they can often avoid those taxes, too. That makes helping governments build vital infrastructure all the more attractive.

Investors have responded to the rally by pouring $18.2 billion into muni-bond funds through October, according to Lipper, which tracks fund flows. By comparison, investors yanked $48.4 billion out of munis over the same period last year, amid widespread concern that Detroit’s record bankruptcy and Puerto Rico’s debt woes pointed to broader problems with municipal finances. Muni bonds lost 2.55% in 2013.

Munis make the most sense for investors who pay a lot in taxes and can use the bonds to lower their tax bill. In fact, even though munis typically have lower yields than Treasurys or corporate bonds, they may provide more income once you take the tax advantages into account. Many of the issuers also carry strong credit ratings.

To compare the returns on munis to those on Treasurys or corporate bonds, divide the muni’s yield by 1.00 minus your tax bracket. So an investor in the 25% federal tax bracket would divide a muni yield by 0.75 (1.00 minus 0.25). Therefore, a municipal bond yielding 2% would be the equivalent of a taxable bond yielding 2.67%. The higher the tax rate, the better munis can look. The advantages can be even greater when state and local taxes come into play. An investor who is in the highest federal income-tax bracket and lives in New York City, for example, would need to get a 3.79% yield on a taxable bond to match the return on a 2% muni, given state and local taxes.

The debt problems made investors wary of muni bonds and officials wary of issuing them, which has curtailed supply. Municipalities have issued $265.6 billion of bonds this year through October, a 6.3% decline compared with the same period in 2013, according to data from the Securities Industry & Financial Markets Association, a trade group. (And 2013 issuance marked a decline from 2012.) This year, however, demand bounced back. In October, when turmoil in the stock market sent many investors fleeing for cover, yields on muni bonds dipped below 2% for the first time in two years. Yields fall as prices rise.

Investors, therefore, may be tempted to seek out higher-yielding munis, which often means buying riskier debt or bonds that won’t be paid off for a long time. Duration is a measure of how sensitive bond prices are to changes in interest rates. The longer a bond’s duration, the sharper the price moves. Instead, investors should be patient, and look for short-term muni-bond funds, whose holdings typically mature in less than five years. That way, investors can roll into higher-yielding munis if interest rates rise.

Still, if you buy a bond with a decent yield from a reliable issuer, current prices shouldn’t be too much of a deterrent, experts say. The best strategy might be to buy a low-fee muni-bond fund that holds bonds issued by a variety of state and local governments. But be aware that owning a nationally diversified fund can somewhat limit the tax benefits, because fund investors typically only get a break on state and local taxes on the portion of bonds that come from their home state.