Background
Municipal Bonds also known as Munis’ are Bonds issued by State and Local Governments who use the money to finance projects. The payments for these Munis are made from the taxes they collect. It is extremely unlikely (but not totally unheard of) for a Municipality/City/State to go Bankrupt and stop making payments on their Bonds. Most municipalities have credit rating that are relatively low. If they had a higher credit rating they would have to pay lower interest rates on the money they borrow. To get a higher credit rating for their bonds the government entity issuing the bonds can insure them with a AAA credit insurer aka a Monoline insurer. Once insured with a AAA credit insurer the bonds receive a AAA credit rating and have to pay much lower interest rates.

How the subprime mess has affected Muni’s
Most of the companies that provided insurance of Munis also started insuring CDO’s (Collateralized Debt Obligations). The companies have to pay the mortgage companies if the homeowner fails to pay and the house sells for less than the cost of the loan. As everyone has read/heard, there are an unprecedented number of people who are unable to make payments on their house. House prices are down and the mortgage companies are losing money. This in turn means that when they cant recover the original loan the Monoline insurers have to make payments. The market feels that the amount of payments that some of these companies need to make to cover the CDO obligations will leave little capital left to cover the obligations of the Insured Munis. Since the feel that the Monolines wont have money left to pay for insured Munis they are treating the Munis as if they are uninsured.

Whats the opportunity
As I mentioned earlier it is very rare for a government entity issuing Munis to go bankrupt. Another thing is that the interest from Munis is not taxable at the Federal level. If you buy Munis that are issued by entities in the state you live in the income is exempt from state taxes as well. Because the income is not taxed at Federal level and sometimes not taxed at state level, Munis usually have lower yields than US Treasury’s. The reason being that after tax a Muni yield of 6% is similar to a 8% yield that gets taxed at 25% income tax rate.

Here are some examples based on data when i wrote this

US Treasury Yields - 6 Month - 1.56%; 2 Year - 1.55%; 5 year - 2.49%; 10 year - 3.6%
Pimco California Municipal Income Fund - PCQ: 6%
Pimco New York Municipal Income Fund - PNF: 5.4%
Pimco Municipal income Fund - PMF: 6.4%
Individual California Muni Bonds with maturity in the next 5 years

Note : With Managed Funds or Closed End Funds the value of the Fund can go down. Some funds are only allowed to hold bonds with a specific rating eg: A or higher. If the monoline insurers have their credit rating downgraded the rating of some of the bonds the mutual funds hold will also be downgraded and the fund manager may have to sell the Munis at a loss. It may be safer to buy individual Muni Bonds because you can decide to Hold till Maturity. This is not an option when you buy a fund since the fund manager makes the decisions to buy or sell.

Disclosure: I do not hold any Munis but I am considering buying PCQ or individual California Bonds.