Bill Gross is the master of the bond universe. He's the founder and managing director of Pacific Investment Management Co. (PIMCO), the world's largest bond fund. He manages over $600 billion of other people's money -- more than the GDP of most countries on this planet.

So where is Bill Gross putting his money now?

Municipal bonds, and more specifically, municipal bond funds. "I own 35 of these funds personally," Gross said recently. They're "a great deal."

"A great deal"? What's he talking about? Even after 17 successive hikes in the Fed's key lending rate, yields are still paltry just about anywhere you turn in the bond market. 

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It makes little difference if you invest in short-term one-year bonds, intermediate five-year bonds, or even bonds with long-term maturity dates of 10 years or more. Nor does it matter if you invest in government Treasuries, corporate bonds, or municipal bonds. You're still looking at the same puny 5% to 6% yield from all of these bond classes.

Or are you? On the surface, yes. Dig a little deeper, and you'll see why municipal bonds and the funds that hold them offer you a great deal.

Municipal bonds (commonly referred to as "munis") are issued by state and local governments to fund public projects such as the construction of bridges or highways. Backed by the municipalities that issue them, munis are among the most stable, most creditworthy, and highest-yielding bonds around.

In low-return bond markets like today, munis and the funds that invest in them provide investors with a great way to lock in a stable, tax-advantaged income stream while earning superior returns.

"It's not what you earn, it's what you keep"

Let's take a closer look at the yield advantage offered by munis.

Europe's biggest bank, HSBC Holdings, recently issued a five-year single A-rated corporate bond, and this bond is now yielding about 5.5%. You can also lock in a 5-year risk-free Treasury for about 5.2%. Or you can buy a five-year A-rated muni issued by the city of Los Angeles, which also offers a 5.2% yield.

Which is the better investment? All three carry a low-risk credit rating and an equal term to maturity. Your first instinct might be to grab the slightly higher-yielding corporate bond. Alternatively, if you're a conservative investor, then you may go for the risk-free Treasury.

But wait! You may recall that the income you receive from most fixed-income securities, including bonds and CDs, is taxed at your ordinary income tax rate, up to 35%. Not munis -- they're exempt from federal taxes. They also may be free from state and local taxes if they're issued by your home state.

This tax advantage lifts your yield in a big way. In fact, the tax advantage is so huge that Wall Street has developed a whole new vocabulary to speak about munis. Bond investors talk about a muni's "taxable equivalent" yield. That's the yield you would need to get on an ordinary taxable bond to equal what you earn on a muni.

Consider this example. The muni just issued by the city of Los Angeles yields 5.2%. That's less than the HSBC bond yield of 5.5%. However, the catch is that you'll need to pay federal taxes on the HSBC bond.

Using a taxable-equivalent yield calculator, which you can find on just about any financial website, you'll see that the HSBC corporate bond would need to yield around 8.7% to match the yield on the tax-free muni (assuming you pay a combined federal, state and local tax rate of 40%).

Here's another way to look at the difference. Your after-tax return on a $100,000 investment in the 5.5% corporate bond would be just $3,575 if you're in a 35% federal tax bracket. (We won't count any state or local taxes you may pay.) Compare that to the $5,200 you get to keep with a $100,000 investment in a 5.2% tax-free muni. Compounded over five years, the difference really adds up. Your corporate bond would earn a total of $19,200 at maturity -- well below the $30,696 you'd earn by investing in the muni!

By the way, these calculations also apply to government-issued Treasuries, which, like corporate bonds, are subject to federal income taxes (but not most state and local taxes).

Of course, the muni's tax-advantaged yield may not be as appealing if you hold all your investments in a tax-exempt account. When you withdraw a muni from an IRA or 401(k) type of account, it becomes subject to taxes just like any other investment. With this in mind, municipal bonds are best kept in a taxable (ordinary brokerage) account.

Aside from their tax benefits, munis also enjoy many other advantages . . .

Munis are Safe
For starters, munis are among the safest bonds around -- about as safe as Treasuries. Over the past three decades, their default rate has been only 0.04% versus 9.8% for corporate bonds, according to credit rating agency Moody's. While some muni funds invest in the high-yield (below investment grade) sector of the municipal market, the funds we'll profile in a moment focus on quality, investment-grade bonds.

What about interest rate risk? When interest rates move higher, bonds decline in value. But here again, munis could be even safer than Treasuries. That's because overseas investors have bulked up on Treasuries. If these investors decide to bail out, then Treasury prices could sink and the Treasury you buy today could be worth a lot less tomorrow.

Munis are not likely to suffer the same fate. Over 70% of munis are owned by individual investors like you and me, who generally hold their bonds to maturity. As such, municipal bond prices tend to stay relatively stable. Over the past 20 years, muni prices have fluctuated less than 5% annually, far less than the 15% volatility of the S&P 500 or even the 7% change in Treasury bonds, according to research by investment banker Franklin Templeton.

Why Buy a Bond Fund?
You can buy individual municipal bonds or you can invest in a fund that holds a diverse portfolio of munis. Municipal bond funds generally offer higher yields than individual muni bonds. They also give investors the benefit of greater diversification, as well as the opportunity for capital gains.

Most muni bond funds invest in a diverse portfolio of different municipal bonds. This spreads the risk across several different state and local governments and a range of sectors. Muni funds also have the resources to create a laddered portfolio of dozens of bonds with different maturities, allowing them to take advantage of changes in interest rates.

Mutual Funds or Closed-End Funds?
You can gain exposure to municipal bonds by investing in mutual funds and/or closed-end funds. Because closed-end funds typically offer higher yields and lower management fees, I've focused my research efforts on several top yielding closed-end funds. The following funds have built high-quality bond portfolios that should provide stable, secure income for years to come . . .

Important Note:  Throughout the remainder of this article, editor Carla Pasternak provides a closer look at some of today's highest-yielding municipal bond funds, many of which sport taxable equivalent yields of 10.8% or more. However, in order to view the remainder of this article, you'll need to subscribe to our premium income-oriented newsletter -- High-Yield Investing. After you subscribe you'll receive immediate access to this full article, as well as our monthly High-Yield Investing newsletter and a host of additional premium content. Please visit one of the following links to continue...

Good investing!

Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com

Carla has been employed in the investment industry for more than two decades. In addition to her work as a writer for several other nationally recognized financial publishers, her previous experience includes a position as President of a well-respected investor relations firm. She has also been writing shareholder reports for public companies (annual reports, speeches, corporate profiles, slide shows, etc.) since 1980.

A highly successful investment analyst, Carla specializes in high-yield, income-paying stocks. In that pursuit, she's always mindful to select companies that not only pay rich dividends, but that also have the potential to deliver strong long-term capital gains.

On the educational front, Carla holds both MBA and Ph.D. degrees. When she's not watching the market, she's teaching business courses at the college level and managing several million dollars in portfolio assets.

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