High-Yield Municipals Look Set to Rise

Even after paying for insurance and financing, hedge funds earned a tidy profit from the interest on their municipal portfolios.

Then last summer trouble appeared. Some hedge funds began selling municipal bonds in order to cover their losses in mortgage markets. As problems appeared with bond insurance companies, money markets stopped buying short-term debt from hedge funds. That halted the leveraged purchases of munis.

The problems culminated in February, when big investors dumped municipals wholesale. High-yield funds lost 5.6%, their worst monthly performance since 1980.

"Unusual circumstances came together and hurt municipals," says Geoffrey Schecter, portfolio manager of MFS Municipal High-Income (MMHYX Quote).

The downturn pounded investment-grade and high-yield munis alike. But in recent months, high-grade munis have recovered sharply. High-yield bonds have been slower to rebound, as investors have been wary of taking on extra risk.

Still, the odds seem good that lower-quality munis will enjoy a strong year. Since 1981, high-yield muni funds have never suffered two losing years in a row. Most often, downturns have been followed by healthy rallies. For example, the funds lost 4.6% in 1994, when interest rates rose. The following year, the high-yield muni funds came roaring back, returning 16.3%.

A similar performance is not impossible this year. The default rate for high-yield municipals remains tiny. Leveraged trading no longer roils the tax-free markets. And the election could boost muni prices. Democrats are promising to raise taxes. That would increase the tax advantage of munis, encouraging investors to bid up bond prices.

For the moment, demand for high-yield munis is muted. Wounded hedge funds are sitting on the sidelines. But agile investors can gain an edge by buying high-yield funds while they are still at bargain prices.