Fans of tax-free muni bonds know that inflation can gnaw at their returns. And as government spending stokes fears of rising inflation, investors might be looking for protection.

One possible solution: J.P. Morgan’s three-year-old Tax Aware Real Return Fund — one of the only mutual funds to combine municipal bonds with a shield against inflation.

The fund works by investing in high-quality municipal debt, which is not federally taxed. (As of March 30, 93% of bonds were AAA-, AA-, or A-rated.) It uses inflation protection derivatives, such as inflation-linked swaps, to keep pace with the Consumer Price Index.

By holding swaps and bonds of similar durations, the fund is hedged about 1 to 1. In theory, a drop in bond prices should be offset by an increase in the value of the swaps. (Of course, the same swap would reduce the potential gain on the bonds.) Read the rest of this entry »