High-Yield Municipals Look Set to Rise

The credit crunch has slammed corporate junk bonds and bank loans. But of the 30 fixed-income categories monitored by fund tracker Morningstar, high-yield municipal funds rank dead last for the 12 months through July 15, losing 5.33%. In contrast, intermediate municipal funds gained 4.19%, and long government funds returned 15.23%.

Now there are good reasons to expect that high-yield municipals can rebound and outperform most bond classes in the next year.

Many high-yield bonds look cheap compared to alternatives. When bond prices fall, yields rise, and that has occurred in tax-free markets. High-yield muni funds that yielded less than 5% a year ago now yield 6.0% or more. That is the equivalent of a taxable bond yielding 8.3% for an investor in the 28% tax bracket. The rich yields on the funds seem particularly appealing at a time when 10-year Treasuries pay 3.8%.

High-yield funds -- which focus on bonds rated below investment-grade -- yield about a percentage point more than intermediate municipal funds with investment-grade ratings. That is a wider spread than normal and a big change from a year ago, when the gap was only 25 basis points, or one-quarter of a percentage point.

"Last year, high-yield bonds looked expensive, and now they seem cheap compared to other municipals," says Mark Otterstrom, portfolio manager of Waddell & Reed Municipal High Income (UMUHX Quote).

Besides paying fat yields, high-yield munis seem like relatively stable investment vehicles, says Timothy Pynchon, portfolio manager of Pioneer High Income Municipal Fund (PIMAX Quote).

"The balance sheets of most hospitals and other issuers look fine," says Pynchon.