Municipal bond mutual funds increased 14.4% on average through Oct. 29 and yields have not experienced their current lows in more than four decades, reports Jonathan Burton for The Wall Street Journal. The surge in muni bonds may be over, but some believe this investment vehicle still have a place in many portfolios, especially as tax time looms. (The current bond hot spots).

Many states face deep budget deficits, potential downgrade risk and headline risk. Bonds usually drop in price when credit ratings are bad or when budget deficits are high.

Still, muni bonds appeal to investors because of of their tax-free income status. Munis are generally exempt from federal and state level taxes. Their tax-free status will become more appealing as federal income taxes become higher as the Bush administration’s tax cuts expire at the end of 2010.

Currently, the supply/demand imbalance is supporting the price of municipal bonds. Professionals suggest potential investors stick to bonds with at least a single-A rating. They also note that long-term bonds are more susceptible to interest rate changes and don’t provide enough to compensate. (What you need to know about bond ETFs).

For more information on municipal bonds, visit our municipal bond category.

• PowerShares Insured National Muni Bond (NYSEArca: PZA): up 16.3% year-to-date; yields 4.5%

• iShares S&P National Municipal Bond (NYSEArca: MUB): up 5.9% year-to-date; yields 3.6%

• SPDR Barclays Capital Municipal Bond (NYSEArca: TFI): up 8.1% year-to-date; yields 3.68%

• Market Vectors Long Municipal (NYSEArca: MLN): up 20.4% year-to-date; yields 4.49%

Max Chen contributed to this article.

According to Randall W. Forsyth of Barron’s, the rally has been specifically seen in the credit markets, in particular corporate securities as opposed to lower-risk Treasury securities.

One reason that bond ETFs are remaining attractive it because the credit markets are giving investors a better return than the near-zero return earned in money-market and cash accounts.  Additionally, with the ever-growing number of options available, bond ETFs enable investors to make both bearish and bullish plays on the market.

If the economy improves, corporate credit will benefit. If this happens, Treasury yields are apt to rise. Conversely, if the economy falls short of the bulls’ expectations, Treasury yields may fall but corporate spreads could widen and hurt corporate bond returns. Have a strategy in order to protect yourself.

The iShares iBoxx $ Investment Grade Corporate Bond (NYSEArca: LQD) is up 9.3% year-to-date and has a yield of 5.33%.

The SPDR Barclays Capital High Yield Bond Fund (NYSEArca: JNK) is up 31.3% year-to-date with a yield of 12.9%.

Even municipal bonds have seen a nice uptrend.  Take a look at the iShares S&P National Municipal BondETF (NYSEArca: MUB) which is up 8.7% year-to-date with a yield of 3.63%.  Additionally, State Street Global Advisors recently launched the SDPR Standard & Poor’s VRDO Municipal Bond ETF (NYSEArca: VRD),which is designed to provide investors with access to muni variable-rate demand obligations.

For more stories on bond ETFs, visit our bond ETF category.

Kevin Grewal contributed to this article.

For full disclosure, Tom Lydon’s clients own shares of LQD.

Assets: $1.3 billion

Holdings: The fund holds investment-grade municipal bonds, rated at least BBB- by Standard & Poor’s, Baa3 by Moody’s or BBB- by Fitch. Each bond must be denominated in U.S. dollars and have a minimum term to maturity of one calendar month.

Objective: MUB seeks to track the iShares S&P National AMT-Free Municipal Bond Index.

What’s Good

• MUB has an expense ratio of 0.25% with 409 holdings
• Yields 3.64%
• It’s up 6.1% year-to-date
• Muni bonds are exempt from federal taxes and, in some cases, state and local taxes

The Latest News

• Among fixed-income funds in the third quarter, municipal bonds nabbed seven of the top 10 spots
• There is still a large amount of debt hanging over many state and local economies, so demand for debt investments could remain high, according to analysts
• Municipal bond ETFs offer many benefits as they give investors a low-cost and safe way to invest in the municipal market
• Since municipal bonds are more transparent than any other bond, you know exactly where your money is

Go here for more ETF Spotlights.

Although there is a large debt hanging over state and local economies, the demand for debt investments should stay in high demand, according to analysts. Individual investors are scooping these investments up and the acceptance rate of these are high. Money News reports that demand was evident in the first-quarter’s big finish, with the issuance of about $12 billion in debt in the final week of the quarter, including a massive California deal, making this the best advance since December 2006.

The second largest flow into this investment area was seen in mutual funds, which posted a net inflow of $13.9 billion last quarter. The rush proved rewarding for retail investors who bought into municipal bond mutual funds, said one Lipper analyst. The quarterly performance of muni bond funds of 4%- 7% returns shows that the performance is attractive.

The authorities have pumped more than $1 trillion into the economy and lowered interest rates to nearly zero, leaving the possibility of inflation looming further down the road, but it’s not an imminent factor. This is another reason many investors have flocked to this area of the market. Investors should keep an eye out for inflation in the future, however.

Municipal bond ETFs offer many benefits as they give investors a low-cost and safe way to invest in the municipal market. And since municipal bonds are more transparent than any other bond, you know exactly where your money is.

• iShares S&P National Muni-Bond ETF (MUB): up 3.4% year-to-date; 3.6% yield

If you are searching for a bond-focused ETF to help round out your portfolio or keep assets in safety, the good news is there are about 58 different bond funds on the market. Jeffrey R. Kosnett for Kiplinger explains that this is more than enough to build any imaginable income portfolio, taxable or tax-exempt, using ETFs exclusively.

Overall, bond ETFs are pretty straightforward, easy to interpret and fill investment needs expediently. Among the ways they can be used:

• Treasury ETFs come in a range of maturities, and you can shift them up or down depending on where you think interest rates are headed. If you think they’re heading up soon, then long-term bonds would take a hit.
• With corporate bond ETFs, you can select from a few ETFs that target hunk bonds. There are also a number of ways to access investment-grade funds, as well.
• Worried about inflation? Try TIPS (Treasury inflation-protected securities). iShares Barclays TIPS Bond (TIP) and SPDR Barclays Capital TIPS (IPE) have an average maturity of nine years, and buys TIPS across the yield spectrum. The so-called Tips funds are are good preparer for inflation, which many say is looming ahead of us in the near future. Richard Lehman for Forbes says that while people are talking so much about deflation, what people should be wary of is inflation. While inflation can provide short-term relief, it’s harmful in the long run because it stifles real growth, hurts productivity and hurts savers.
• If you just can’t decide, try a total bond market ETF. The Vanguard Total Bond Market Index (BND) and iShares Barclays Aggregate Bond Fund (AGG).
• Municipal bonds are proving to be a safe haven in these current market conditions. Under “normal” market conditions, the tax-free municipal bonds usually yield less than taxable bonds. Since the market is upside down right now, the non-taxable bond can actually offer better yields than most. Since states and towns can raise taxes to meet debts, muni bond defaults are extremely rare (but still possible). iShares S&P National Municipal Bond (MUB) and SPDR Barclays Capital Short-Term Muni Bond (SHM) are two ways to access this market.

Discuss fixed-income in our forums. How do you use these ETFs in your portfolio?

A few bond funds and their charts:

• iShares Barclays Aggregate Bond Fund (AGG) down 1.9% year-to-date; current yield 4.53%

• iShares Barclays 7-10 Year Treasury Fund (IEI): down 0.61% year-to-date; current yield 2.79%

• SPDR Barclays Capital Long Credit Bond ETF (LWC): up 1.2% year-to-date

Retirees and income-oriented investors alike enjoyed gains averaging 4.6% in the six national, short and intermediate-term tax-free municipal bond ETFs on the market. Municipal bonds have been overlooked because of their slow, but sure nature.

Chance Carson for Index Universe reports that the muni-bond area is proving to be a safe haven in these current market conditions. Under “normal” market conditions, the tax-free municipal bonds usually yield less than taxable bonds. Since the market is upside-down right now, the non-taxable bond can actually offer better yields than most.

Since states and towns can raise taxes to meet debts, muni bond defaults are extremely rare (but still possible). If you’re looking for high yields and low taxes, munis look like one of the best deals out there, says John Waggoner for USA Today.

Some of the municipal bond focused ETFs on the market:

• iShares S&P National Municipal Bond (MUB): up 0.89% year-to-date, yields 3.55%

• SPDR Barclays Capital Short-Term Muni Bond (SHM): up 1.6% year-to-date; yields 2.52%

• Market Vectors Short Municipal ETF (SMB): up 3% year-to-date; yields 2.57%

The plus side is that the new muni ETFs provide a safer, lower cost way of investing in municipal bonds than either municipal bond mutual funds or direct investments. The bad news? Today’s investment climate is so crazy that market watchers warn that the muni market could be rough this year.

As an investment vehicle, muni ETFs have a lot going for them. Generally, fees are about half of a municipal bond fund-0.20% to 0.40%, compared to 0.50% to 0.80%. Right now, even if it’s just half a percent you’re saving, that’s a lot of money.

Muni ETFs are also more transparent than most bond funds, which only have to report what they held last quarter. They’re slightly more liquid, too. Unlike mutual funds, which can only be sold at the net asset value of the prior day’s closing price, muni ETFs can be sold at the prevailing price any time during the day.

There’s not been a hiccup as far as trading, the spreads have been very reasonable and manageable, reports On Wall Street.

On the plus side, yields are high right now relative to U.S. Treasuries. In ordinary times, municipals trade at yields a little lower than Treasuries, pricing in their tax advantages.

Munis are also tax-free, of course, and double-tax free if your client is a New Yorker or Californian who buys a home-state muni ETF. Defaults can happen, but are rare, at least compared to corporates. The major downside to the muni market is that since the insurance is not available, institutional investors steer clear of this investment class. Both leveraged investors and individuals are not interested in munis either.

To cope with the downside risk of a muni ETF, keep your eye on the 200-day moving average, and if the fund falls below this, it may be time to get out.

• iShares S&P National Municipal Bond ETF (MUB): up 1.2% year-to-date; up 0.4% for one week; 3.55% yield

The beauty of the bond market is that there is a plethora of choices on the market and one can fine tune his exposure to the sound of his liking. 2008 was a big year for investors in Treasury debt, but it looks like 2009’s winner may be elsewhere, perhaps in corporate debt or in municipal bonds.

Jonathon Burton of The Wall Street Journal breaks down the bonds into the following three categories:

• Broad Exposure- these generally track a benchmark for the broad U.S. investment-grade bond market. A good cheap way to play this market is through the Vanguard Total Bond Market (BND), which has an expense ratio of 0.11% and boasts a 4% yield.
• Short Term- these ETFs allow you to be cautious towards a potential increase in interest rates. A possible play here could be the iShares MBS Bond Fund (MBB), which charges 0.36% and yields 3.8%.
• Muni-Bond- These have came under scrutiny due to the massive shortfalls in revenues seen by local and state governments. The sector is a bit riskier, but will also give a higher yield. We think that this is an area to keep an eye on; after all, the infrastructure portion of President Obama’s stimulus plan will be focused on state and local governments. One play here could be the iShares S&P National Municipal Bond (MUB), which gives a 3.8% yield, tax free.

There are plenty of options out there for investors to play the field. Be cautious, do your homework and remember that you don’t always have to hit for the fences.

Jo Eqcome for Seeking Alpha points out that 41 out of 50 states are reporting budgeting shortfalls for the year 2009, with prospects of bankruptcy looming. Muni bond ETFs are poised to do well, for the following reasons:

• Fixed-income markets are on the mend, thanks to improving credit markets
• A Federal stimulus package would support the muni bond market, as the new Presdidency takes action
• Investment characteristics such as discounts to NAVs and spreads to Treasuries
• Year-end tax selling may cause a “bounce”

The muni ETF have lower management fees than the closed end fund (CEFs) and use little leverage, among other differences. They offer a conservative approach to long-term investing within the muni bond market.

• PowerShares Insured National Muni Bond Fund (PZA): down 9.8% for one year

• iShares S&P National Muni Bond Fund (MUB): up 1.7% for one year

After several sessions of declines, municipal bonds and the exchange traded funds (ETFs) that track the sector seem to be attractive and might be a great bargain.

• Yields on AAA-rated general obligation muni bonds are about 1.5% higher than those of Treasuries and these tools are generally tax-exempt.
• Another reason muni bonds have appeal is that rising deficits, especially in states such as California, Minnesota and Ohio, will keep yields high. Muni bonds will eventually deviate back to their normal prices, may give you a gain, but will not translate into quick riches.

Although muni bonds are tempting, they aren’t foolproof. The bond market has been hit by leveraged investors fleeing causing a severe lack of liquidity and credit downgrades to bond insurers, states Mina Kimes of Fortune Magazine. This raises the issue of default in these bonds – in tough times like these, many cities are nearing bankruptcy.

Another issue coming up in the bond market is a new nationwide inquiry that’s been launched. Federal agencies and some state attorneys general have been gathering evidence of what might be collusions among banks and companies that have helped state and local governments take about $400 billion worth of municipal notes and bonds to market every year, reports Mary Williams Walsh for The New York Times.

The issue is concerning now, because the incoming administration is preparing a stimulus package that would spawn projects carried out and financed at the state and local level. Some estimates have as much as $4 billion a year vanishing into the system.

If interested in this market, a sampling of the many funds are: PowerShares Insured National Muni Bond (PZA) has a yield of 5.11% , with a taxable equivalent of about 7.8% ; iShares S&P National Municipal Bond Fund (MUB) has a yield of 3.7%, with a taxable equivalent of about 5.6%; SPDR Lehman Municipal Bond ETF (TFI) has a yield of 3.9%, with a taxable equivalent of about 6%.