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.

AXA Equitable defines a bond as an IOU for money loaned by an investor to the bond’s issuer.  In return, the borrower agrees to pay the investor interest at a stated rate.  One benefit of bonds is that they generally move in the opposite direction of stocks.

Bonds do offer diversification, but come with some risks, too:

• Market risk.  Market risk is generally only a concern if one plans on selling the bond before its maturity date.
• Interest-rate risk.  This risk comes into play due to the inverse relationship between interest rates and bond prices.
• Credit risk. This deals with the likelihood that the bond issuer will go into default before the bond reaches maturity.  The higher the yield of the bond, the more likely it will default.
• Inflation risk. The risk here is that the total return from bonds will not outpace inflation.

Now that investors know the pros and cons of bonds, here are a number of ways to play the bond market.

• One could look at corporate bonds, which are bonds issued by corporations.  The primary risk with these bonds is credit risk and all interest is taxed at ordinary income tax rates. A way to play corporate bonds is the iShares GS $ InvesTop TM Corporate Bond Fund (LQD): which is up 3.4% year-to-date and has a yield of 5.6%.

• Another class of bonds to look at are government bonds, which are issued by the U.S. Treasury and are backed by the full faith and credit of the U.S. government.  These generally present inflation risk and are fully taxable at the federal level, but exempt at state levels.  A way to grab exposure to these is through the iShares Lehman 7-10 Yr Treasury Bond Fund (IEF), which  is down 7.2% year-to-date and has a yield of 3.93%.

• A third way to grab exposure to bonds is through municipal bonds.  These are issued by state, county, city or local authorities and are advantageous because of their generally tax-exempt status.  A way to grab exposure to these bonds is through the SPDR Lehman Municipal Bond ETF (TFI) which is up 5.6% year-to-date and has a yield of 3.89%.

For more stories on bonds, visit our bond category.

Kevin Grewal contributed to this article.

In a capricious market, investment gurus usually provide sage advice and tell the investor to stick the course for the long-term investment, reports Eleanor Laise for The Wall Street Journal. Market conditions are just right for a meticulous investor to shift through the rubble and find that bargain opportunity.

According to The Guru Investor, O’Shaughnessy conducted a four-decade-plus study of stock returns and strategies and says stocks could still reach new lows. Nevertheless, the values out there are too good to pass up.

John Bogle, found of Vanguard Group, has about 25% of his portfolio in stocks while David Dreman, chief investment officer of Dreman Value Management LLC, has around 70% stock allocation. It is up to personally preference and experience that has decided which investment tool has been most trustworthy. These are some of the sectors and related ETFs that the experts deemed note worthy:

• Rob Arnott, chairman of Research Affiliates LLC, thinks it’s time for investing. Mr. Arnott favors Treasury inflation-Protected Securities, or TIPS iShares Lehman TIPS Bond (TIP), a Treasury bond that is adjusted based on inflation rates. He anticipates a future increase in inflation in the next 3 to 5 years.
• Long-term investors are also looking into municipal bonds, SPDR Lehman Municipal Bond ETF (TFI), because they are usually exempt from federal, state, and local income taxes. Burton Malkiel, an economics professor at Princeton, has boosted allocations to highly rated tax-exempt bonds in his taxable account.
• Mr. Arnott also increased allocations to investment-grade corporate bonds, iShares iBoxx $ Investment Grade Corporate Bond (LQD), because of “irrationally high yields.”
• Pummeled stocks in the energy sector also look like bargains, oil and gas exploration and production companies, PowerShares Dynamic Energy Exploration And Production (PXE) would experience growth if we aren’t left in a prolonged recession.
• Mr. Bogle has restrained himself from investing too much in international stocks, but Mr. Arnott says that if emerging-market stocks, iShares MSCI Emerging Market (EEM), drop any lower then they could become “extremely interesting.”
• Jeremy Siegel, senior adviser for WisdomTree, has stated that high-yield stocks, SPDR Lehman High Yield Bond (JNK), will move together after our market crisis passes. Siegel has also increased allocations into U.S. real estate investment Trusts, or REITs, SPDR Dow Jones Wilshire REIT (RWR).

Our strategy is to put 25% of the value of your portfolio when a fund crosses above its 50-day moving average. When the fund goes up 5%, put another 25% in. Watch for the long term-trend lines, and continue to go in incrementally, until the 200-day moving average is in sight.

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%.

In the first year of their existence, ETFs with the primary goal of coupling price with the underlying muni index experienced the illiquidity of a hectic bond insurance industry, according to Dan Seymour for On Wall Street.

Muni ETFs try to mimic their indexes with holdings in a sample of bonds from the indexes. The ETFs collect coupon payments from bonds they hold, then distribute them as dividends. These ETFs are not known for their fat returns, but merely reflect the performances of their underlying indexes.

Among the many markets vying for President-elect Barack Obama’s attention is that of the muni bond. Obama’s tax plan could be conducive to the future performance of muni-bond ETFS, because of the after-tax yield.

It should be noted that the design of muni ETFs face two risks during market unrest: The price of the ETF may drift from the value of its assets or the the value of an ETF’s bond sampling may fail to reflect the overall index.

With greater diversity than individual muni bonds, muni ETFs spread the risk that potential investors would have be exposed to.

Short muni ETFs are designed to provide income and some protection against wild vacillations in the market while the long index carries a greater interest rate risk. But for the intrepid investor, the long index and its greater risk carries with it a greater annualized yield.

The benefits of muni bond ETFs that most investors enjoy are the ability easily sell the ETF to move to another investment and the exposure to tax-exempt debt without researching individual muni credits.

Muni ETFs vary by maturity and by location. ETFs offer exposure to indexes in municipal credit from California and New York.

Among the many such ETFs available include:

• iShares S&P National Municipal Bond Fund (MUB), down 2.2% year-to-date.

• SPDR Lehman Municipal Bond (TFI), down 2.8% year-to-date

Treasuries advanced on Tuesday, pushing yields down, as concerns about the health of the banking system here pulled investors back to the safety of government debt, reports Deborah Levine for MarketWatch. It didn’t help that this morning, concerns arose over the ability of Lehman Brothers (LEH) to raise capital.

Traders are noting that Treasurys still face pressure, as the government may have to issue more debt in the coming quarters to support the mortgage agencies.

Some Treasury bond ETFs include:

• iShares Lehman TIPS Bond (TIP), up 5.2% year-to-date
• iShares Lehman 20+ Year Treasury Bond (TLT), up 7.1% year-to-date

Municipal bonds and the ETFs that focus on them are one of the most popular and interesting investments for 2008. Eileen Ambrose for The Baltimore Sun explains that investors in high-income tax brackets favor the bonds because the interest income generated is exempt from federal taxes and, in some cases, state taxes. Investors also flock to municipal bonds for safety.

Bond insurance is now an issue, as this is what guarantees the interest payments and principle on bonds in case of default. Muni-bond insurers in recent years have gone and started insuring riskier securities that involve the subprime mortgages. You can guess where that led, and now issuers are offering a higher rate on bonds to attract investors. Lucky for some investors, bond yields are up.

ETFs offer good access to municipal bonds, as they track a benchmark of bonds and they can be broken up and traded through out the day. Some of the many available municipal bond ETFs are:

• SPDR Lehman Municipal Bond ETF (TFI), up 2.1% year-to-date
• PowerShares Insured National Municipal Bond Portfolio (PZA), down 1.4% year-to-date
• iShares S&P National Municipal Bond Fund (MUB), up 1.9% year-to-date

Fund companies have been churning out these new types of ETFs over the past year, and if you believe tax rates are going to go up, then these ETFs may look even more attractive, says Eleanor Laise for The Wall Street Journal.

The troubled times have actually weighed these funds down, with the credit crunch and mortgage meltdown in full effect. The bonds are so bogged down, they may actually be a good buy now, some say.

While muni-bond funds do have many tax advantages, their yields are lower than those of U.S. Treasury bonds. Municipal bonds are issued by state and local governments, and often times are exempt from federal, state and local income tax.

As of now, safety-minded investors have fled toward the Treasury bond ETFs, and this has actually driven the prices up and the yields down. The rseult has been that they’re now about equal with the muni-bond. Muni-bond ETFs have low costs and the average expense ratio is at 1.01% of assets. Investors who believe tax rates are going to go up have a reason to consider the bonds.

Laise recommends the calculator at Investing In Bonds – you can enter your state, net taxable income and tax-filing status to see the yield you need to earn on a taxable security to match the tax-free yield of a muni bond.

Some to choose from:

• iShares S&P National Municipal Bond Fund (MUB), up 0.6% year-to-date
• PowerShares Insured National Municipal Bond Portfolio (PZA), down 3.1% year-to-date
• SPDR Lehman Brothers Municipal Bond (TFI), up 0.7% year-to-date
• Market Vectors-Lehman Brothers AMT-Free Short Municipal Index (SMB), up 2.2% since Feb. 28 inception