In the USA Municipal bonds are issued by state and local governments and are exempt from federal tax. Therefor if you earn a 5% yield your after tax return is equal to that of a 7.5% yield if you are in the 33% federal tax bracket (7% * .67 = 5%). One way to invest in bonds is using a mutual fund (open or closed end funds). Right now the tax equivalent yields (compared to other bonds) of muni bonds are higher than normal.
Muni Bond Funds Offer High Yields, Tax Perks Dec, 2007:
With so many defaults going on in the mortgage arena, investors are worried that the insurers won’t be there to back up any munis that might get into trouble. A fair point, but the bond insurers are bolstering their own capital structures to deal with these concerns, and historically, as I said before, defaults in munis are few and far between.
Why are closed-end muni funds trading at a discount? Typical discounts today are about 10%, which is about as deep as such discounts have ever gotten on a historical basis. The typical discount is half that, or less. Closed-end muni funds sometimes even trade at a premium.
One explanation for the big discount might be the fact that many closed-end muni funds use leverage, in order to increase the tax-exempt returns they can offer investors. In the current credit crisis, leverage is seen as an inherently dangerous thing.
In general I find bonds to be a less desirable investment. Especially in the low yield environment recently (and really going back quite a few years). But for diversification some bonds can make sense for certain portfolios. Given the current tradeoffs (risk v. after tax yield) muni bonds certainly deserve consideration. I would shy away from long term bonds or funds (intermediate or short term) but of course every investor makes their own decisions.