It’s the most frequent question readers have asked me lately.

Is there a buying opportunity thanks to the sell-off in municipal bonds and muni bond funds?

Municipal bonds are issued by states and municipalities to fund public works. Generally they are considered safe, but in November many muni funds saw their biggest one-day price drop since the financial crisis. Investors withdrew a record $5.4 billion from municipal bond funds within two weeks last month, according to Lipper FMI. Some funds fell by 5% or more, and many hit 52-week lows.

So what exactly is going on, and more importantly, is this a chance to buy municipal bond funds for cheap and lock in attractive yields on some of the safest securities available?

Believe it or not, this sell-off wasn’t entirely unexpected. The pattern of a sell-off at year-end and a rebound in January is well-documented. It occurs when some investors sell before the end of the year to lock in their gains or losses for tax purposes. Then, they buy back the same shares in January.

#-ad_banner-#Typical year-end tax issues may help explain the sell-off. But this year there has been an unusual combination of forces at work that have amplified the selling and the potential opportunity.

For one, many states and municipalities are seeing record-high deficits, which show few signs of abating. Muni investors may be demanding higher yields (lower prices) to compensate for the higher risk of default.

At the same time, the recent election gave more control to Republicans. The victory could spell an end to the Build America Bonds program, which is set to expire at the end of December. If that program expires, the supply of traditional tax-exempt municipal bonds in the marketplace will increase by an estimated +35%, pressuring prices. In addition, the seemingly imminent decision to extend the Bush-era tax cuts means tax-advantaged municipal bonds will become less attractive for some investors.

Many of these concerns have been looming for some time, however, and likely have been priced into the muni market. Something else must have sparked the sell-off…

One catalyst may have been the Federal Reserve’s plan to buy $600 billion of short-maturity Treasury bonds. A buyback was expected, but most investors were surprised the Fed chose to focus on shorter-maturity bonds.

What does this have to do with the muni sell-off?

Muni bonds generally track Treasuries. By supporting short maturity bonds, the Fed positioned these for more modest losses than their long maturity peers. Some long maturity bonds lost as much as 10% of their value in the initial sell-off, but short maturity bonds fell only slightly — less than 2% in many cases. There are always exceptions, but generally shorter-term muni bond funds appeared to hold up better than their longer duration peers during the sell-off. That bodes well for a quick comeback in the new year.

Getting back to the original question, I think there is a year-end buying opportunity in municipal bond funds, as long as you stick with funds that meet a few guidelines.

(Note: If you’re a conservative investor, you might want to wait until a bottom is in place before investing in these muni funds — even those of the highest quality. The sell-off has been sharp and could continue in the weeks ahead.)

Action to Take –> To pick 2011’s winners, I’m looking for funds with short maturities, taxable-equivalent yields above 6%, and high-quality portfolios rated “A” or higher by Standard and Poor’s. (Risk of default is already higher for most bonds because of rising government deficits, so avoid portfolios of questionable quality.)

This leaves you with a list of funds like Delaware Investments Minnesota Muni Income Fund II (AMEX: VMM) that have been part of the sell-off, despite being safe and high-yielding. Come 2011, I think it’s this sort of find that will lead in a potential rebound.

P.S. — If you’re looking for tax-advantaged income, it’s hard to beat municipal bond funds. But if you want higher yields, there are definitely other places to look. I’ve put together an educational piece on some of my favorite high-yield hunting grounds in my free course: The 5 Rules Every Income Investor Has to Know… And 3 Picks to Start Profiting Today. Click here to start reading.