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The credit market woes have benefitted buyers of municipal bonds. With long-term tax-free yields that can top 6%, Barron's Andrew Bary says munis have almost never been so attractive relative to U.S. Treasurys.

The market has been hurt by a wave of redemptions and a scarcity of buyers. There are also concerns that a weakening economy will lead to budget deficits for state and local governments, damaging the credit quality of municipal debt. Historically, however, muni bonds have had a better credit performance than corporate debt, and overall muni default rates remained very low even during the Great Depression.

The yields can be staggering too. Last week, 30-year bonds backed by the triple-A-rated Texas Permanent School Fund sold at a yield of 6.25%. Double-A-rated New York City issued bonds yielding up to 6.40%. Top-grade 10-year debt can yield 5% or more. A 6% muni yield is equivalent to a 10% taxable yield for residents of high income-tax states like California, New Jersey and New York, assuming residents buy in-state bonds, with 9% tax-equivalent yields for out-of-state bonds.

Long-term munis have historically yielded less than U.S. Treasurys because of the tax benefits, but the 5.9% yield on 30-year, AAA-rated munis is now around 135% of the 4.3% yield on the 30-year Treasury, the highest ratio in the past 20 years. Demand for long-term issues is weak, but short-term options abound. California just sold eight-month notes at an attractive 4.25% yield, especially when compared to the 1% rate on Treasury bills.

Investors have plenty of options for playing the muni market, including individual bonds, open-end mutual funds (VWITX, SNDPX, SMMOX), closed-end funds and muni ETFs (NYSEARCA:MUB). Closed-end muni funds reached record discounts of 30% or more this month relative to their net asset values, way above the typical 10-15%, but there's a risk that some closed-end funds will reduce leverage and thereby diminish yields.

The hardest hit big muni fund this year is Oppenheimer Rochester National Municipals (MUTF:ORNAX), down 37% as of Thursday. Prices of bonds in the Rochester portfolio have fallen sharply on investor preferences for munis rated AA or above, and Rochester has been forced to sell bonds at a disadvantage. Even so, the credit quality of Rochester and the larger Rochester Fund Municipals (MUTF:RMUNX) remains strong with minimal defaults, and the main short-term risk is that the funds will need to sell additional bonds to cover redemptions.

Investor preferences for highly rated munis are reflected in the near-record 2% yield gap between triple-A and triple-B munis. Amongst high-grade bonds, there is a further investor preference for general-obligation bonds and revenue bonds from well-regarded issuers, including the L.A. Department of Water and Power and the Port Authority of New York and New Jersey.

Source: Muni Bonds Boast Attractive Yields - Barron's