Earlier this month, I told you about this year’s biggest income opportunity – tax-free municipal bonds.

Municipal bonds are loans made to state and municipal governments. To encourage folks to invest in the government, interest received from “munis” is exempt from federal income tax and, in many cases, state and local income taxes.

Everyone is so terrified of ballooning government debt these days, municipal bonds have suffered a huge selloff: $30 billion has exited municipal bond funds in about three months. So many people have bailed out of them, the yields on these things have gone to absurd levels, in some cases hitting a taxable-equivalent 10%.

[ad#Google Adsense]You can hardly blame investors. As I told you before, Wall Street sensation Meredith Whitney went on 60 Minutes and predicted 50-100 “significant” municipal bond defaults that would add up to “hundreds of billions of dollars.” Scary! And she wasn’t the only one spouting doom and gloom.

But the tune is starting to change. The bears are backing off. That’s going to lure the investing herd back in… and it’s going to shut this income window fast.

Last week, in an interview with USA Today, Whitney said that while some localities will still default, the situation isn’t as bad. The reason? States are taking “stronger austerity measures.

I told you as much a couple weeks ago. And I pointed out an even more important argument:

The key question surrounding default is whether the municipality can cover its interest payment, or “debt service.” Turns out the debt service makes up a small part of the average state budget. The ratings agency Fitch reports debt service is “less than 10% of the government’s budget.”

Income and property taxes are half that percentage at the state and local levels. Hardly reasons to renege on municipal debt.

It seems like the public is starting to catch on. John Hallacy, head of municipal research for Bank of America Merrill Lynch, said this past week was the biggest muni bond issuance week of the year – with over $4.3 billion sold.

The biggest muni bond fund is the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX). Shortly after Whitney made her claims about massive defaults, VWITX plunged below $13 a share. But as you can see from the chart below, it’s already rebounded about 30 cents.

And yields on the best 10-year muni are down 24 basis points (0.24%) since February 1.

So the big opportunity is shrinking. But it’s still a great deal. You can still find high-single-digit tax-equivalent yields.

First, look to see if there are bonds in your state… If you own those, the money is completely free from federal and state taxes. You can find individual bonds through brokers like Schwab and Fido. But be sure to diversify your portfolio with at least five different bonds… You don’t want to see the only one you bought default. And look for bonds that don’t have a super-long maturity… If rates go up, you’ll see the value of the bond go down, and you might have a hard time holding it.

If you’re more interested in investing in a “one click” bond fund, I recommend low-turnover funds. That means they don’t trade to make money – they pick long-term investments. And for bond funds that’s good, because you’re not selling at a loss if rates go up.

We already knew the evidence was against mega-bearish calls on municipal bonds. The talking heads are finally starting to catch on. The public won’t be far behind. It’s time to get in before it’s too late.

Here’s to our health, wealth, and a great retirement,

— Doc Eifrig

[Daily Trade Alert note: If you’re looking for a specific muni bond idea, consider the Nuveen Insured Municipal Opportunity Fund (NYSE: NIO). This fund pays a taxable equivalent yield of around 10% in monthly installments. Read more…]

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Source:  Daily Wealth