In Search of a No-Load, High-Yield Municipal Bond Fund

Any opinions on (HRHYX)Heartland High-Yield Municipal and (SHYLX)Strong High-Yield Municipal? Both are open-end, no-load municipal bond mutual funds.

-- Ron Lane

Ron,

Rather than looking just at the two high-yield muni bond funds you asked about, I looked at the entire universe of no-load, high-yield muni funds. And what I found was that it's tough to go wrong in this little subset of the muni world.

There are only 13 funds in the group, and once you exclude the tiny ones (assets under $2 million), which are expensive to run, you're left with nine, including the two you mentioned.

No Dogs Allowed The no-load, high-yield municipal bond fund universe is lacking in losers
Fund	Expense ratio	Inception	1999 Rank *
(ABHYX)American Century High-Yield Municipal	0.65%	1998	6
(HRHYX)Heartland High-Yield Municipal	0.76	1997	13
(HRSDX)Heartland Short-Duration High-Yield Municipal	0.62	1997	1
Northern High-Yield Municipal	0.85	1998	47
(SHYTX)Scudder High Yield Tax Free	0.84	1987	9
(SRHMX)Stein Roe High-Yield Municipal	0.75	1984	6
(SHYLX)Strong High-Yield Municipal	0.70	1993	44
(SSHMX)Strong Short-Term High-Yield Municipal	0.60	1997	2
(PRFHX)T. Rowe Price Tax-Free High-Yield	0.71	1985	42
Source: Lipper. *Of 58 high-yield municipal bond funds.

First and most importantly, none of them rip off investors with a super-high expense ratio. While it is typical for no-load funds to have lower expense ratios than their broker-sold counterparts, the difference in the high-yield group is striking. The highest annual expense ratio among the nine funds is 0.85%, compared with a category median (excluding institutional funds) of 1.07%. (Among no-load munis, the median is 0.73%.)

And this is a category that has no Vanguard offering. Vanguard, with its roughly 0.20% expense ratios for bond funds, keeps pressure on its no-load competitors to keep their expenses low. (Vanguard does run a muni fund that is high-yield in name, (VWAHX)Vanguard High-Yield Tax-Exempt. But the fund is not classified as a high-yield fund by Lipper because it doesn't invest at least half its assets in lower-rated bonds. Accordingly, it won't act like a high-yield fund. Still, its 0.20% expense ratio has helped it perform better over the last five years than all the no-loads except Scudder and Stein Roe.)

Which is not to say you should pick a fund based on its expense ratio alone.

You should also look at how the funds have acquitted themselves in recent years.

This is where it starts to get complicated. Five of the nine funds are less than three-years-old. So you can look at how they did last year and in 1998, but that's all you have to go on.

Still, if you'd held any of the nine funds over the last couple of years, with the exception of Northern High-Yield Municipal, you wouldn't have much to complain about. And Northern has to be cut some slack for having gotten off the ground in 1998, in the middle of a bull market, only to suffer through the bear market of 1999.

All the other funds either put together a couple of respectable performances or have better-than-average five-year records.

The main difference between the funds -- and this is something you should also consider -- is the extent of their reliance on bonds with below-investment-grade ratings or with no ratings at all. Every high-yield muni fund is going to have some, but some funds have a lot more than others.

The two funds you asked about (and their counterparts from the same family) rely heavily on nonrated and junk muni bonds. According to their latest filings, Heartland High-Yield Municipal and (HRSDX)Heartland Short-Duration High-Yield Municipal had about 95% of their assets in nonrated and junk bonds. Strong High Yield Municipal was 79% nonrated or junk bonds and (SSHMX)Strong Short-Term High-Yield Municipal was 74%.

That compares with 22% for the five-year leader, (SHYTX)Scudder High-Yield Tax-Free (the best-performing of all muni high-yield funds over the period), and 31% for (SRHMX)Stein Roe High Yield Municipal, the second-best no-load muni fund over the last five years.

Which is not to say you'd be unwise to buy one of the junk-laden funds. It would be especially hard to argue that after Strong Short Term and Heartland Short Duration just put together the two best two-year results among the no-loads. And that's even after Heartland Short Duration finished 1998 with the second-worst record in its category because of a problem with one of its bonds (a total return of 3.63%).

They managed that primarily because they are short. In a year like last year, when all bond prices fall because interest rates are rising, the prices of short-maturity issues fall the least. So both funds had positive total returns last year, the only two high-yield muni funds to do that. Instead of taking on interest-rate risk, these funds take on credit risk.

If you're going to cast your lot with them, you should understand what that means. It means that in an economic downturn, these funds might suffer more than their share of defaults, which would hurt their performance. By the same token, if the economy stays strong, you can expect them to outperform their longer-duration counterparts.

Unfortunately, it's too early to say whether the short-duration, high-yield strategy, over the long term, will prove as successful as the more cautious approach taken by Scudder and Stein Roe.

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