MONEY

Munis on the Rise

Yuri Kozyrev—NOOR for TIME The village of Wadi Zahr, outside of Sanaa.

You’d think that with bankrupt Detroit fighting to slash payments to its bondholders, Chicago’s debt being downgraded because of pension problems, and Puerto Rico’s credit rating being reduced to “junk” status, these would be hard times for municipal bonds. Well, you’d be wrong.

Munis lost as much as 6% in the middle of 2013, owing to those troubled locations and the effects of rising interest rates. Now they’re making a bid for comeback investment of the year.

Debt issued by states and municipalities has beaten the broad fixed-income market so far this year, continuing a trend that started last September. Since then munis, whose income is exempt from federal (and in many cases state) income taxes, have returned 5.5%, vs. 3.2% for taxable bonds.

Why the turnaround? Part of it has to do with value.

In January, MONEY noted that fiscal worries in high-profile cases were creating real bargains. Now, the health of the broader market is also looking up for these reasons:

Today’s headlines are masking a broader truth. Crises in Detroit and elsewhere belie the fact that the U.S. economy is gradually healing to the point where state and local coffers are on the mend. Last year, for instance, less than 0.11% of high-grade munis defaulted, down from 0.23% in 2011.

Much of the market’s pain has already been felt. Credit problems in Detroit and Puerto Rico contributed to muni fund losses last year, as did rising interest rates, which lower bond prices.

Long-term rates are likely to drift higher this year if the Federal Reserve continues to taper its stimulus efforts, but market watchers say most of the damage was done in 2013 when yields on 10-year Treasuries nearly doubled from 1.6% to 3%.

Related: Americans Still Worried About Their Financial Future

“Unless there is some external shock, we don’t expect rates to go significantly higher from here,” says Peter Hayes, head of BlackRock’s municipal bond department.

The policy backdrop has changed. Talk of limiting tax breaks on munis, which sprang up a few years ago, has died down. At the same time, the new 39.6% top income tax rate is here for couples earning more than $450,000 a year (the old top rate used to be 35%).

There’s also a new 3.8% surtax on certain investment income, from which muni income is exempt. That surtax is levied on top of capital gains taxes for couples with modified adjusted gross income of $250,000 and singles at $200,000.

“The tax-free interest of municipal bonds should get more attention in light of those new tax rates,” says James D’Arcy, manager of Vanguard Intermediate-Term Tax-Exempt VANGUARD INTERM-TERM TAX-EXEMPT INV VWITX 0.21% , which is in the MONEY 50, our recommended list of mutual and exchange-traded funds.

Munis offer an income advantage. If you hold bond investments in taxable accounts, munis deserve a serious look — and not just if you’re in the top bracket. Consider that the Vanguard Total Bond Market Fund, which owns a diverse mix of high-quality U.S. corporate and government issues, sports an after-tax yield of 1.5% for those in the 28% income tax bracket. By contrast, Vanguard Intermediate-Term Tax-Exempt pays you 2.1%.

Of course, risks remain. Rates could climb higher than expected. And with bond insurance coverage down significantly on new issues ever since the financial crisis, the municipal market is going to be more volatile than you might assume, says Lyle Fitterer, co-manager of the Wells Fargo Advantage Intermediate Tax/AMT-Free SIMBX 0% .

So you’ll want a smart strategy like the one below:

Find the sweet spot in high grade

In a potentially rocky market, don’t go with high-yield junk bond funds, which sank more than 10% amid the worst of last summer’s muni storm. Stick with high-quality municipal debt instead. Within that universe, BlackRock’s Hayes recommends looking for portfolios with big stakes in single-A-rated munis (investment-grade issues are rated AAA, AA, A, or BBB).

Over the past decade, Hayes says, A-rated bonds have outperformed the broad market in up years while performing no worse than average in down years.

Vanguard Intermediate-Term Tax-Exempt keeps about a third of its assets in As, while Wells Fargo Advantage Intermediate Tax has more than 40% — well above the 23% category average.

Take a long look at intermediate-term bonds

Investors have been rushing into bonds maturing in five years or less lately because these securities aren’t as vulnerable to rising interest rates as are long-term bonds. The result: “Bonds with three- to five-year maturities are the richest part of the market right now,” says Robert Miller, co-manager of the Wells Fargo fund.

On the flip side, payouts for 10-year A-rated bonds have risen from 1.6% last year to 2.1% today.

Related: Fresh Thinking on Income Investing in a Low-Yield World

Going whole hog into long-term issues, though, sets you up for some stomach churning when rates rise. The solution: Seek out funds with around a five-year average “duration” but that also have a decent slug of long-term exposure. (Duration is a measure of rate sensitivity. If market rates were to rise 1 percentage point, a fund with a five-year average duration would lose around 5% in price, while a 10-year duration fund might drop twice as much.)

A good example is Fidelity Intermediate Municipal Income FIDELITY INTERMEDIATE MUNI INCOME FLTMX 0.19% . The fund sports an average duration of 5.6 years, yet around half the portfolio matures in a decade or more.

Build a ladder — but one’s that long enough

In a rising rate environment, laddering your debt — in other words, holding various bonds that mature in routine intervals — makes sense.

There are new types of exchange-traded funds managed by iShares that invest in munis that all mature in the same year, making it possible to ladder funds. Unfortunately, the longest-dated version of these muni ETFs matures in just five years. To capture the market’s extra yield, you’d want to make sure the oldest bonds in your ladder come due at least a dozen or more years from now.

If you go with individual securities, strategists recommend sticking with high-quality revenue bonds. Their payments are backed by income from an essential service, such as water and sewer projects or electric power plants.

Related: The Easiest Way To Juice Your Portfolio? Minimize Taxes

And make sure you have at least 10 rungs in your ladder, says Rob Williams, director of income planning for the Schwab Center for Financial Research. That means buying 10 munis, the first that matures a year and a half from now; the next, three years from now, the one after that, 4½ years from now, and so on, until you get to 15 years.

By doing so, you’ll enjoy higher yields that longer-date bonds offer without going overboard. And as interest rates rise, you can reinvest maturing bonds into new 15-year securities paying ever-higher yields.

In the new muni landscape, where opportunities are presenting themselves even as risks remain, that’s how to get a leg up.

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