bond funds

4 solid muni bond bets

December 12, 2012: 5:00 AM ET

Municipal bonds still have a role to play for smart savers.

FORTUNE -- There are legitimate reasons to fear a municipal bond bubble, as my colleague Allan Sloan warns in his column. A torrent of money is pouring into the sector, hiking up prices and lowering yields. But if you're smart about your strategy, investing in the $3.7 trillion market for tax-exempt bonds can still provide strong and safe after-tax returns.

Here are two mutual funds that offer good yields yet guard against the principal danger in munis -- a sharp rise in interest rates. Fidelity Intermediate Municipal Income (FLTMX) offers a yield of 2.9% and low fees. T. Rowe Price Tax-Free Income (PRTAX) provides a somewhat higher yield of 3.86%, in part because manager Konstantine Mallas is skilled at buying bonds that can be "called," or paid off early by the issuers. Because of the uncertainty, they usually offer higher yields.

If you live in a high-tax state such as New York or California, you'll have to pay state and local levies on out-of-state bonds, so you may want to concentrate on local issues. In New York, Lebenthal muni expert Greg Serbe recommends New York State Dormitory Authority bonds, backed by Columbia University, maturing in 2021 with a yield of 3.1%. In the Golden State, he likes Sacramento County Airport System, at 3.0%.

This story is from the December 24, 2012 issue of Fortune.

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