Municipal Funds Veer From Safety to Danger

The credit crisis has clobbered most bonds. But the damage is especially notable in municipal markets. During the 12 months ending in November, municipal long-term funds lost 9.1% of their value, according to Morningstar. High-yield municipal funds dropped 20.4%.

What makes the losses so unsettling is that tax-free bonds normally seem stodgy. Because many of them are backed by tax revenues, municipals rank as the second-safest category behind Treasuries.

Most often, municipal funds grind out single-digit returns. Only a percentage point or so often separates the top performers in the category from also-rans. This year, returns were all over the map, ranging from single-digit gains to losses of more than 30%.

The big disparities occurred because the markets punished some sectors more than others. While high-quality bonds proved relatively resilient, shakier issues sank. At the same time, investors dumped long bonds and fled to short issues. In addition, some funds were weighed down by investments in inverse floaters and other derivatives, which collapsed in the market panic.

Investors did best in plain-vanilla funds that focus on quality short-term issues. Among the winners was Vanguard Short-term Tax Exempt(VWSTX), which returned 3.8% for the 12 months. At the other end of the spectrum was Rochester National Municipal(ORNAX), which owned derivatives and low-quality issues, holdings that caused the fund to lose 40.6%.

The varying results demonstrate why investors should understand what their municipal funds hold. In a sector that can seem blandly homogenous, portfolio managers follow different strategies. Investors who have suffered big losses should re-evaluate their holdings and consider funds that now seem poised to deliver winning results when the markets revive.