Capitalize on Hedgies' Demand for Muni Bonds

These private investment partnerships are using muni bonds to juice their investment returns, which aren't as stellar as they were a few years ago. But hedge funds aren't just buying the bonds and collecting interest.

Rather, they are employing various arbitrage strategies to profit from the difference between the yields paid by longer-dated muni bonds and other, shorter-dated securities. One such strategy involves using the bonds as collateral in trusts that issue variable-rate notes.

Demand from these kinds of programs has boosted prices on municipal debt and enabled this asset class, which is usually associated with predictable, if unexciting, tax-free income, to outperform both U.S. Treasuries and corporate bonds for the past three years, according to data from Bloomberg.

So even if you aren't wealthy enough to afford the steep investment minimums for hedge funds, you can capitalize on the strategies they employ by investing in closed-end funds that invest in municipal bonds.

True, when demand for muni bonds pushes prices up, the effective yield on these securities falls, reducing an investor's potential return. But most muni bond funds are already fully invested, and since they made many of their purchases before the recent run-up in prices, they're still getting good yields.

Moreover, when prices on the bonds in their portfolios rise, they mark the value of the securities up, recording an unrealized capital gain. Of course, if the funds eventually sell the securities and realize the gains, they have to put their money back to work -- hopefully in an area of the market or specific muni instrument that has not experienced a run-up in price.

The list below shows the closed-end municipal bond funds that TheStreet.com Ratings' models recommend. Top Rated MUNICPAL Bond Funds:  Table