High net worth baby boomers on the cusp of retirement are in a pecuniary pickle: rather than looking to get rich, they need to stay rich.

But with yields on long-term Treasuries stubbornly low relative to short treasury rates, and international bond yields even lower than US treasury rates, it is getting harder to find superior returns on fixed income investments.

The fund management industry has something for them to think about: muni­cipal bond funds. The funds – made up of bonds issued by state and local governments to bankroll hospitals, roads, schools, subsidised housing and stadiums – are especially attractive because of their tax efficiency.

“It is a no-brainer that a core holding of [a high net worth individual’s] asset allocation should be in muni bond funds,” says David Hamlin, managing director for the tax-exempt fixed income team at money manager Putnam. “They have a high credit quality, they are not especially volatile, they outperform taxable counterparts and by investing in them you are supporting growth of the US economy.”

According to Financial Research Corporation, the Boston-based data company, municipal bond funds had a solid first half of 2006, with flows totalling $730m in May.

Year-to-date flows are about $3.9bn, down slightly from the same period last year, when they took in $4.3bn. The category is being driven by high-yield muni­cipal bonds, which accounted for 69 per cent of this year’s new money. Much of that can be attributed to high-yield bonds’ strong performance and the high demand for yield in the market, according to FRC.

Some financial experts advocate owning municipal bonds individually. They argue that “laddering” – which involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year – is an ideal way to invest in munis. This is because the strategy captures price appreciation as the bonds age and their remaining life shortens, and it reinvests principal from maturing bonds into new longer-term bonds.

But individual ownership is expensive – it typically requires a minimum investment of $25,000 to get the best price – and there are some important benefits to investing in a fund. According to Mr Hamlin: “You get daily liquidity, which in the muni market is sometimes scarce. You get diversific­ation, which is near imposs­ible for individual investors, and you get the benefit of analysts and research staff who know which below-investment grade bonds may be worth the risk.” These advantages arguably justify the fees.

Another benefit of muni bond funds as opposed to muni bonds is that investors have access to a smooth income stream with monthly dividends.

The primary advantage of these funds is their tax efficiency. Any interest you earn from a conventional bond fund is taxed at your own income tax rate but municipal bonds are exempt from federal taxes. In addition, investors who back state-specific muni bond funds from the state in which they live get their interest free from either state or local taxes.

Muni bonds yields are not especially high – the yield on a 10-year AAA-rated muni bond is about 4.18 per cent, while a 10-year Treasury yields 5.25 per cent – but in this business fund managers like to talk about “taxable equivalent yields”. In other words, how much more yield you are getting because of the tax benefits. To calculate a muni bond’s taxable equivalent yield, divide the tax-exempt yield by a factor of 1 minus your tax bracket. For instance, if you are in the 35 per cent tax bracket, this factor is 0.65. Therefore tax­able equivalent yield on a tax-exempt fund that yields 4.5 per cent is 6.92 per cent.

Some industry observers expect muni bonds to outperform Treasuries as the municipal supply decreases. In 2005, new muni bond issuance was $408bn – the most in 10 years. But as interest rates have risen there is less incentive for governments to issue new bonds and muni­cipal issuance is expected to drop significantly, with current estimates at about $300bn this year.

“There has been a record issuance of munis because we are in a record low interest rate environment,” says Tom Metzold, portfolio manager of Eaton Vance’s flagship municipal bond fund. “We are going to see fewer and fewer. Of course, that will mean higher prices and higher yields.”

The tightening supply situation in the municipal bond market has been exacerbated by rising demand. “Larger tickets are being written,” Mr Metzold says. “We have a lot of pre-retirement people who have made $5m and are looking for capital preservation and tax-free interest. Then again, we also have people in their 80s and 90s who have got $200,000 in a muni fund and are using it to reduce their risk profile.”

Non-traditional buyers of muni bonds, including foreign institutions and hedge funds, have also been buying up munis. “Historically, there has not been a lot of interest from arbitrageurs and foreign buyers but Europeans are now using them to get fixed income and diversify their portfolios,” says Putnam’s Mr Hamlin.

As bond funds go, returns on muni bond funds are respectable. According to Lipper, the fund data company, high-yield municipal debt funds have returned 3.89 per cent in the past 12 months and 5.69 per cent in the past five years. General bond funds are up 1.44 per cent and 4.56 per cent in the same period.

Municipal bonds are considered safer than corporate bonds but according to Dieter Bardy, mutual funds analyst at Morningstar, muni bond funds are not for everyone. “For short-term investors on the hunt for yield, the case for muni bond funds is not particularly compelling,” he says. “But for long-term investors who do not mind a bit of day-to-day volatility, intermediate to long-term muni bond funds do offer an attractive yield.”

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