A couple of weeks ago, I wrote about the virtues of municipal bonds (or muni bonds).

In one sense, the timing was perfect. Since the dreaded tax filing deadline was right around the corner, it was a great occasion to talk about why investors (especially upper-income taxpayers) should consider muni bond funds as a way to earn tax-free income.

But in case you haven’t noticed, interest rates continue to head higher. And the first and most important rule of fixed-income investing is that bond prices move inversely to interest rates. So bond prices have generally dropped.

So today, I thought I’d take some time to address this. You see, I think an opportunity is setting up in muni bonds funds right now — and savvy income-minded investors could lock in higher yields and scoop these funds up at a nice discount.

Recap: The Benefits Of Munis

Before I go any further, let’s recap the major benefits of muni bonds.

As I’ve mentioned before, cutting the IRS out of the loop can make a big impact on your portfolio (particularly when dealing with larger dollar amounts).

Let’s compare a $100,000 initial investment in a taxable bond fund yielding 5% and a comparable muni fund paying 4%. The corporate bond fund would generate $5,000 in annual interest. But when April 15 rolls around, Uncle Sam will take his share, reducing the income to just $3,150 for those in the top tax bracket.

Meanwhile, the muni fund would throw off $4,000 in pure tax-free income.

That might not sound like much of a difference. But we’re talking nearly a full percentage of after-tax yield. Compounded over 10 years, the muni fund would accumulate to $148,024, versus $136,362 for the taxable fund — putting almost an extra $12,000 in your pocket.

Between you and me, I can think of plenty of ways to spend those tax savings.

The Opportunity

Back in my previous article, I mentioned Eaton Vance Muni Income (NYSE: EVN) as one of my top picks for investors interested in muni bond funds.

Thanks to rising rates, EVN has slipped about 18% thus far in 2022, a sizeable decline in the normally staid municipal bond market. The pullback has little to do with declining credit quality, rising defaults, or other fund-specific factors. In fact, EVN continues to rate five stars from Morningstar over the intermediate (3-year) and long-term (10-year) time frames — outrunning 99% of its category peers.

As a reminder, the hand-picked portfolio spans more than 300 “A”, “AA”, and “AAA” rated securities, many of which are revenue bonds tied to the construction of toll roads, hospitals, and water and sewer infrastructure projects. Holdings include bonds issued by New Jersey Transit, Chicago Board of Education, Miami Dade Aviation, and San Diego Water Authority.

While the Fed’s rate tightening presents short-term headwinds, several macro trends are working in our favor.

Among others, the number of state rating upgrades has doubled the number of downgrades in recent years. Much of the credit goes to a strong housing market rebound, which has inflated property taxes — putting more money into municipal coffers. Healthy job creation has also boosted consumer spending, leading to the collection of more city and state sales taxes.

Even when the economy is sluggish, municipal bankruptcy filings are still exceedingly rare.

Meanwhile, the Biden administration has just floated one of the biggest tax hikes on record. While any legislation surrounding next year’s budget proposals (which include higher dividend and capital gains taxes) would have to win the support of a divided Congress, the discussion alone could increase investor appetite for tax-exempt securities.

Thanks to the recent dip, EVN’s payout has increased to about 5.2%. For those in the 37% tax bracket, that equates to a tax-equivalent yield (TEY) of 8.2%. In essence, that’s what a taxable bond fund would need to yield to match this tax-free payout.

Action to Take

There’s something to be said for tax-exempt income backed by the “full faith and credit” of state and local governments. As long as there are income taxes, municipal bonds will always attract buyers looking to keep the IRS out of their pocket.

And EVN is currently trading at a 10% discount to its net asset value (NAV). While we aren’t out of the woods on rate hikes yet, management will be reinvesting maturing bonds and accumulated interest into new securities with richer yields.

As I recently told subscribers to my High-Yield Investing premium newsletter, I think we’ll eventually look back at the $11 area as a buying opportunity.

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