High-Yield Municipals Look Set to Rise

The credit crunch has slammed corporate junk bonds and bank loans. But of the 30 fixed-income categories monitored by fund tracker Morningstar, high-yield municipal funds rank dead last for the 12 months through July 15, losing 5.33%. In contrast, intermediate municipal funds gained 4.19%, and long government funds returned 15.23%.

Now there are good reasons to expect that high-yield municipals can rebound and outperform most bond classes in the next year.

Many high-yield bonds look cheap compared to alternatives. When bond prices fall, yields rise, and that has occurred in tax-free markets. High-yield muni funds that yielded less than 5% a year ago now yield 6.0% or more. That is the equivalent of a taxable bond yielding 8.3% for an investor in the 28% tax bracket. The rich yields on the funds seem particularly appealing at a time when 10-year Treasuries pay 3.8%.

High-yield funds -- which focus on bonds rated below investment-grade -- yield about a percentage point more than intermediate municipal funds with investment-grade ratings. That is a wider spread than normal and a big change from a year ago, when the gap was only 25 basis points, or one-quarter of a percentage point. ...