This Once-Dead Market Is Heating Up

Even after more than three years, the financial crisis has had some lasting impacts. Finally, though, one market that got crushed by the credit crunch that accompanied the market's meltdown in 2008 and early 2009 has started to perk back up -- and investors are taking notice.

Most people see the bond market generally as a less exciting place to invest than stocks, commodities, and other riskier investments. Even though bond prices have gotten somewhat more volatile over time, bonds are still a market in which every hundredth of a percentage point is important -- a stark contrast to stocks, where you can expect much wilder moves almost every day.

But even among bond investors, municipal bonds are considered the sleepy backwater of the market. Compared to the trillions of dollars in Treasuries, the muni bond market is small, and returns generally can't compare to what you can find from corporate bonds.

Recently, though, that's changing. Two factors are to blame: fears about rising tax rates and the return of bond insurance to the scene.

Municipal bonds are appealing to investors because their income is free from federal income tax. Therefore, for investors in the higher tax brackets, a conventional bond would have to yield 50% more than a muni bond just to break even after taxes. If you choose a municipal bond issued within your own state, you can also get a state-tax break, which adds to the advantage.

The downside to the muni market is that as with any bond issuer, problems with the financial health of the states and cities that issued bonds raised concerns about whether they'd get repaid. Analyst Meredith Whitney made a call predicting a possible collapse of the muni market, as cash-strapped municipalities would have no choice but to default on their debt. Although a few high-profile cities have gotten into financial trouble, the full extent of Whitney's Munigeddon scenario hasn't come to pass.

The other positive for muni bonds is that after a tough few years, companies are starting to look at providing bond insurance on munis again. Assured Guaranty (NYS: AGO) has managed to stay financially healthy enough to write new bond insurance, and it sees the potential for new competition in the near future.

That's a big change from a few years ago, when many other companies weren't so fortunate with their muni-bond insurance. Ambac Financial's bankruptcy came largely from its insurance on mortgage-backed bonds, but it was also a player in the muni-bond insurance market. MBIA (NYS: MBI) and Radian Group (NYS: RDN) also had muni-bond insurance exposure, although Radian sold its muni-bond insurance subsidiary to Assured Guaranty earlier this year. Even Berkshire Hathaway (NYS: BRK.B) provided muni-bond insurance for a while, but the company chose to get out of the market in 2009, as Warren Buffett argued that cities might well not have the political will to hurt their constituents in order to repay distant investors.

If some of these companies get back into the market, it could lead to more insured bonds getting issued. That in turn could bring safety-seeking investors back into the muni market. That might hurt the value of outstanding uninsured bonds, but it could lead to increased overall demand for munis that could in turn bring yields down and support the entire market.

As with other bonds, you can buy individual municipal bonds from most brokers, or you can concentrate on mutual funds and ETFs. The iShares S&P Nat'l AMT-Free Muni ETF (NYS: MUB) has attracted almost $3 billion in assets, but owning bonds from around the country, it won't maximize your state-tax benefits as much as some other funds. A wide range of closed-end funds and traditional mutual funds can help you focus your exposure as much as you want.

Municipal bonds may not be exciting, but they can provide a useful piece of the fixed-income side of your portfolio. With taxes potentially rising and insurance returning, munis could get a lot more attractive in the near future.

Most investors can't afford to invest only in bonds. Let The Motley Fool show you some promising stocks in our special report on long-term investing, where you'll find names that both produce income and have growth potential. It couldn't be easier: just click here to get your free report today!

At the time thisarticle was published Fool contributor Dan Caplinger likes lower taxes. He owns shares of Berkshire Hathaway, as well as some municipal bonds through closed-end funds. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy insures you'll be satisfied.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.