Investing in bonds is smart for any investor since it adds diversification to your portfolio. But there are many different types of bonds, from savings bonds to corporate bonds to government bonds. As I’ve said before, the best way to invest in bonds right now is short term bonds. But what type of bond investments should you steer away from? In my book, munis or municipal bonds should be largely off limits right now. Here’s why:

Many states and municipalities are facing some of the most challenging fiscal conditions they have faced in decades. That means municipal bonds are also facing challenges. Defaults look poised to rise, and currently munis aren’t priced for it.

My chart shows the spread, assuming a 35% marginal tax rate, between intermediate-term munis and Treasuries. Munis are at their richest valuations in almost two decades. Yes, I understand the top two tax marginal tax rates may increase, but even at a 39.6% marginal tax rate, intermediate-term munis are expensive. At a 39.6% tax rate, you are only picking up an additional 21 basis points in after-tax yield, but you are taking on much more credit risk than you do with U.S. Treasuries. If you are intent on investing in bonds and must own munis, go with Vanguard Limited-Term Tax-Exempt—but for my own money, short-term corporate bonds are the preferred fixed-income investment.

I recommended a number of closed-end municipal bond funds in the November 2008 issue of my Intelligence Report newsletter, which have all performed nicely since. But I am not recommending munis for new money today. I see little value here and would even consider trimming positions given the fiscal positions of many states and municipalities.

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