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Best High-Yield Funds Tilt Toward Safe

Stocks in this article: PIMAX FRHIX IYICX

NEW YORK ( TheStreet) -- High-yield, or junk, bond mutual funds are luring investors turning up their noses at skimpy yields on Treasuries and money markets.

Junk corporate funds currently yield 7.5%, according to Morningstar. But for richer income, consider high-yield municipal funds, which yield 5.4% tax-free. That's the equivalent of a taxable bond yielding 8.3% for someone in the 35% tax bracket. In contrast, the 10-year Treasury yield fell to as low as 3.38% this month.

Wary investors are demanding higher yields on the below-investment grade municipals partly because of the damage that occurred during the credit crisis. With leveraged investors dumping their holdings, high-yield municipal mutual funds lost 25% of their value in 2008.

Since then, the mutual funds have come roaring back, returning 31% in 2009. Now the rally in high-yield municipals has further to go, argues Timothy Pynchon, manager of Pioneer High Income Municipal (PIMAX).

Pynchon says that before the credit crisis, high-yield municipals yielded 125 basis points (1.25 percentage point) more than investment-grade bonds. As the crisis unfolded, the spread increased to 600 points. Now some high-yield bonds continue to yield 300 points more than investment-grade issues.

Eventually, prices of high-yield munis will strengthen and yield spreads will return to normal levels, Pynchon says. "We should see some price appreciation this year."

Pynchon says demand for municipals will remain strong because taxes are all but certain to increase next year when the Bush cuts expire. The top tax rate will rise from 35% to 39.6%. In addition, the health-care legislation imposes new taxes on high-income households. That will make the tax shelter of municipals more valuable and push up their prices.

While demand is growing, supplies of new issues remain tight, Pynchon says. Instead of selling tax-free bonds, many municipalities are turning to taxable issues, which have been subsidized under President Obama's economic-stimulus program. The resulting shortage of tax-free bonds is helping to prop up prices.

Make no mistake, high-yield municipals come with risk. Many low-quality issues are backed by corporations, such as airlines, or nonprofit operations, including private colleges. While default rates are minuscule for investment-grade municipals, high-yield bonds currently are defaulting at an annual rate of around 4.5%.

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