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By Carla Fried

Income investors know full well there are plenty of dividend paying stocks delivering current yields above 4%. Within the S&P 500, AT&T (NYSE:T), Altria (NYSE:MO) and Darden Restaurants (NYSE:DRI) all deliver at least 4%. That said, they also trade at pricey valuations. The same goes for many high yielding MLPs. The ALPS Alerian MLP ETF (NYSEARCA:AMLP), which has Enterprise Products (NYSE:EPD), Magellan Midstream (NYSE:MMP) and Energy Transfer Partners (NYSE:ETP) among its top holdings has a forward PE ratio of 27.

But with the yield on the 10-year Treasury and high quality corporate bonds still stuck below 3% what's an income investor to do?

Check out municipal bonds, that's what.

Even before factoring in the taxable equivalent yield, the nominal yield on the $3 billion iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA:MUB) is higher than Treasuries or high-grade corporates, and the yield for the Market Vectors Intermediate Muni ETF (NYSEARCA:ITM) isn't far off.

MUB Dividend Yield (NYSE:<a href='http://seekingalpha.com/symbol/ttm' title='Tata Motors Limited'>TTM</a>) Chart
(Click to enlarge)

MUB Dividend Yield (TTM) data by YCharts

And on a taxable equivalent yield, munis are crushing it right now. The 2.7% yield on the iShares S&P National AMT-Free Muni ETF has a taxable equivalent yield of 4.5% for anyone parked in the 39.6% federal tax bracket. In the 33% federal bracket your taxable equivalent yield is still above 4%. And even the hoi polloi in the 25% federal tax bracket are getting a nice 3.6% taxable equivalent yield. Investment research tools can help you find out more about the ETF.

The iShares muni ETF has an effective duration of 7.4 years and an average credit quality of Single A. That's firmly in investment grade territory. Yes, junk yields 6%, but that's a taxable 6%, and…it's junk. A 4%+ yield from a high quality bond portfolio seems pretty compelling.

The duration for the iShares muni ETF is only slightly longer than the 6.5 years duration for the Vanguard Intermediate Term Corp Bond index ETF (NASDAQ:VCIT), which has a trailing 12 month yield of 3.1% and the same average Single A credit quality. Sure that 3.1% corporate yield might be tax free to you today if it's tucked inside a tax-deferred retirement account. But that's still at least a percentage point less than the effective yield on an investment grade intermediate term muni portfolio for anyone in the 33% and higher federal tax bracket.

While all bonds got smacked from May-June as the taper talk roiled the fixed income world, munis kept having problems -- or perceived problems - through the summer. The Detroit bankruptcy filing in July and Barron's evisceration of Puerto Rico's precarious economic situation in August pushed muni bond prices lower (and thus, yields higher.)

The total return loss for the iShares S&P muni May-through-August was twice as painful as the slide in the iShares Core Total US Bond ETF (NYSEARCA:AGG), the widely tracked benchmark of the taxable bond world.

MUB Total Return Price Chart
(Click to enlarge)

MUB Total Return Price data by YCharts

The iShares Core Total US Bond ETF does have a lower duration -- about five years -- which explains some of the difference, but not all. Retail investors -- a big factor in muni world -- yanked about $45 billion out of municipal bond mutual funds from May through September, which has put pressure on the notoriously illiquid sector.

Now if you're convinced Detroit and Puerto Rico are just the tip of the iceberg, you'd be right to bail. But they aren't. The default rate on municipal bonds remains below 1% and industry experts insist that there has yet to a problem that wasn't known and visible for years. It's just the same old routine: headlines catch investors' imaginations and they think the entire muni sky is falling. Last time that happened was in late 2010 when Meredith Whitney grabbed headlines with her dire predictions for municipal finances. The iShares S&P National AMT Free Muni ETF took it on the chin, losing 7.1% in the fourth quarter of 2010.

But when the panic dissipated and the market got back to trading on fundamentals, munis rallied. The iShares muni ETF gained 14% between January 2011 and this past May, about two percentage points better than the iShares Core Total US Bond ETF.

The muni market looks like it is once again returning to fundamentals. The iShares muni ETF has gained nearly 3% in the past month, about double the return for the iShares Barclays Core Total US Bond ETF.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Tax-Free Income The Best Revenge: Muni Comeback