Nothing like a terrible year in the stock market to bring back the most boring investment choice out there… bonds!

As an active investor, the very thought of bonds makes me drowsy.  All they do, is sit idle in your brokerage account and collect interest at a slightly higher interest rate than your average savings account or certificate of deposit (CD).  Which, of course, you later pay taxes upon when file your income taxes the next year.

Snooze.

On the other hand, if you’re a shell shocked investor who knows bupkis about the stock market, that idea might sound pretty good to you after seeing your 401k and/or Roth IRA balance drop 10% in a weeks time during Black October.

But I’m not taking the time to write an article about something boring.  I’m writing this because you can buy certain high interest bonds that trade just like stock, but the best part, the interest is tax free!

Higher Capital Gains Taxes are Coming

As I sit here watching the electoral college votes trickle in, I’m taking a long look into our country’s future.  With Senator Obama having a 91% chance of becoming our new President (predicted by InTrade.com), it is highly likely that everyone with a brokerage account will be facing higher capital gains taxes in the near future.

I’m an independent so politics mean very little to me, but as a savvy investor who knows a new tax plan is in the pipeline, people like me will likely seek out ways to circumvent these new tax policies by finding an investment plan that reduces our capital gains taxes as much as possible.

Municipal Bonds are Tax Free Investments

Municipal bonds are essentially a quick way for municipalities to generate cash to pay for public works projects.  When bought, a local city or state government will pay back the original amount of the purchased bond plus a small amount of interest.  Of course, the higher the risk, the higher the interest charged on the muni bond.

As an added incentive, the federal government will give you a tax break on these investments by charging no federal income tax.  If you also buy municipal bonds offered by your state, chances are good that your entire investment will be completely tax free.

Thoroughly researching a bond investment isn’t exactly an easy process.  You have credit ratings to research, ability to pay back the principle plus interest, etc.

Which is why I’m often content to leave it to the professional money managers whose job it is to examine and research these debt related, fixed income securities.  Plus, it’s got to be the most boring job on earth.

Easiest Way to Buy Municipal Bonds is Through Managed Funds

In my opinion, the best way to buy municipal bonds is through no load, low cost mutual funds or exchange traded funds (ETFs).  I generally prefer ETFs because they have a comparable expense ratio to low cost mutual funds, and can be traded at any time throughout the business day unlike mutual funds.

My favorite selections:

1. iShares S&P National Municipal Bond (MUB)
2. SPDR Lehman Municipal Bond (TFI)
3. iShares Lehman 7-10 Year Treasury (IEF)
4. Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX)

For the average person, who almost certainly has a Vanguard account (if you don’t, you should), the best choice available is likely the Vanguard High Yield Tax Exempt mutual fund.  It has an obscenely low expense ratio at 0.15%, and has an excellent rate of return over a 10 year period.

To add one cautionary caveat, municipal bonds are not secured by the FDIC so you will not be protected as you would be with a CD or savings account.  As I mentioned before, the higher the rate of return, the greater the risk.  But considering that municipal bonds are generated by local municipalities, the probability of losing your investment is very low.

Disclosure:  I hold no positions in any of the ETFs or mutual funds mentioned in this article.