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Why Muni Funds Beat Bonds, ETFs

ETFs also provide diversification, but they present risks that were highlighted in the November downturn. The ETFs own baskets of securities and trade constantly on stock exchanges. Most often, the share prices trade for the value of the assets in the portfolios. But in uncertain times, the shares can dip and sell for a discount to the value of assets.

During the week of November 15, discounts reached 2% for ETFs such as iShares S&P National AMT-Free Muni Bond (MUB) and SPDR Nuveen Barclays Capital Municipal Bond (TFI). Investors who sought to sell would have only received 98 cents for every dollar of assets in the portfolio. In contrast, mutual funds always trade for 100 cents on the dollar.

To further the case for buying a municipal mutual fund, municipals represent some of the most attractive fixed-income values, with 10-year tax-free issues yielding 3.10%. That is the equivalent of taxable bonds with yields of 4.3% for investors in the 28% bracket. In contrast, 10-year Treasuries yield only 2.8%.

The Thornburg Strategic Municipal Income fund has the flexibility to roam throughout the bond universe, buying issues of different maturities and credit qualities. This is very different than typical funds, which focus on a single segment, such as long-term high-quality bonds. "We wanted to offer a fund that can take advantage of the changes in municipal markets," says portfolio manager Christopher Ryon.

A year ago, the Thornburg fund began emphasizing bonds rated BBB, the lowest category in the investment-grade universe. The managers figured that the bonds had become undervalued as investors worried about defaults. Thornburg also emphasized longer bonds; they thrive when interest rates fall. The strategy proved on target. During the past year, the fund returned 6.5%, outdoing 98% of its peers.

The greatest long-term danger faced by municipal investors now could be a rise in interest rates. If that happens, bond prices will fall. But Thornburg has the ability to limit interest-rate risk by focusing on short-term bonds. Such bonds can prove relatively resilient in periods of rising rates. By exploiting its flexible mandate, the Thornburg fund may be able to protect shareholders against the hazards of volatile municipal markets.

Municipal funds for difficult markets

-- Written by Stan Luxenberg


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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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