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Make a Killing in the Bond Market

We Fools love looking for opportunity in a beaten-down industry. Thanks to the recent market turmoil, those great values are much easier to find -- especially in the bond market.

With daily headlines detailing bankruptcies, foreclosures, defaults, and big-time writedowns, it's no wonder the bond market has been under so much strain. And don't kid yourself -- the majority of the damage is as justified as it is painful, and it will probably get worse before it gets better.

But when markets are controlled by fear -- justified or not -- you'll often find related investments being sold for no reason, giving you the opportunity to make a killing.

This time around, the opportunity is as in-your-face as it gets. The risk is low, the returns are high, and perhaps best of all, you might not pay a penny in taxes doing so. The red-hot sector of which I speak? Municipal bonds.

You've got to be kidding me
OK, so you might have a hard time picking up a date by bragging about your municipal-bond portfolio. So what? These investments can still make you money.

Municipal bonds' tax advantages make them particularly attractive. Interest income is exempt from federal tax, and even state and local tax, if you play your cards right. When you factor in the tax savings, returns on municipal bonds look almost as appealing -- if not moreso -- than stocks right now. With that in mind, let's dive a little deeper into this typically boring industry.

The market's pain is your gain
Among the CDOs now being felled by subprime bonds, many high-quality, tax-free municipals were thrown into the mix as well. With bond insurers Ambac (NYSE: ABK  ) and MBIA (NYSE: MBI  ) facing possible defaults, CDOs are selling at fire-sale prices, pulling their municipal-bond children down the tube with them. This creates irrational -- even forced -- selling, which should make opportunistic investors very excited.

And with ETFs, investing in municipals has never been easier. For example, the Van Kampen Select Sector Municipal Trust's (AMEX: VKL  ) 5.1% yield gives you a taxable equivalent of 7.08% -- considerably more than the 5.3% the S&P 500 returned over the past decade.

It gets better. The PIMCO Municipal Income Fund (NYSE: PMF  ) yields a taxed equivalent of 8.34%. BlackRock's Investment Quality Municipal Trust (NYSE: BKN  ) puts the equivalent of 7.9% in your pocket. The Pioneer Municipal High Income Trust (NYSE: MHI  ) will give you the equivalent of 7.9%. And you can earn all of that without dealing with the gut-wrenching 500-point market swings we've recently endured.

For such safe investments, those are some serious returns. Municipals, which can include everything from a bridge in Baltimore to a school in Sacramento, have a very, very rare history of defaults.

According to bond giant PIMCO, from 1970 to 2005, the average investment-grade municipal bond defaulted a mere 0.07% of the time, compared with 2.23% for corporate bonds. Even Orange County, when dealing with its high-profile bankruptcy in 1994, made good on its debt.

With such low default rates, municipal bonds may not be quite as safe as Treasuries, but they're pretty darn close. Yet the yield on the 10-year Treasury note stands at 3.67%, and it shows no signs of a rebound. What gives?

Most of the discount, as I mentioned, stems from a crazed, confused debt market -- but that's not the only reason. Simple supply and demand also play a role. Foreign investors have a serious appetite for these bonds, owning more than one-quarter of all U.S. Treasuriees. That extra demand pushes prices up and yields down.

Municipals, on the other hand, get no international love. Their tax-exempt status doesn't matter a hoot to foreigners who don't pay U.S. taxes to begin with. Lower total demand keeps prices low and yields high. That's great news for you and me.

What's your money worth?
You might earn more than 7% holding stocks over the long term, but you'll have to endure periods of dips and bobbles. Municipals, on the other hand, should give you smooth sailing and constant returns throughout your journey. Amid a rising trade deficit, the retirement of baby boomers, and increased competition from foreign countries, 7% may even match stock returns going forward. Add in the possibility of higher taxes early next year, and municipals could get even more attractive.

Sometimes, the blandest, most basic investments make much more sense than high-flying stocks. In today's crazy markets, municipals' time has come.

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Morgan Housel
TMFHousel

Economics and finance columnist for Fool.com. Analyst, Motley Fool One.

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Related Tickers

5/3/2013 3:59 PM
ABKFQ.DL $20.40 Down +0.00 +0.00%
Ambac Financial Gr… CAPS Rating: ***
BKN $15.03 Down -0.01 -0.07%
BlackRock Inv. Qua… CAPS Rating: *
MBI $10.43 Up +0.08 +0.77%
MBIA, Inc. CAPS Rating: **
MHI $15.09 Down -0.03 -0.20%
Pioneer Municipal… CAPS Rating: No stars
PMF $14.24 Up +0.07 +0.49%
Pimco Municipal, I… CAPS Rating: *
VKL.DL $0.00 Down +0.00 +0.00%
VAN KAMPEN SELECT… CAPS Rating: *

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