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Best High-Yield Funds Tilt Toward Safe

Junk-bond funds with investment-grade issues have outperformed riskier rivals.

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

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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%.

With the economy sluggish, the default rate could rise, Pynchon concedes. But he argues that the high yields compensate investors for the risk of default.

To control risk, consider a fund that avoided the worst losses during the downturn. Some of the top performers in the high-yield category keep most of their assets in investment-grade issues and hold low-quality bonds to spice up the mix.

One of the steadiest choices is

TheStreet Recommends

Franklin High-Yield Tax-Free Income

(FRHIX) - Get Franklin High Yld Tax-Free Inc A1 Report

, which has returned 5.4% annually during the past 10 years, outdoing 93% of competitors. The fund yields 5.6%.

Franklin has 72% of assets in investment-grade issues, with the rest in bonds that are unrated or considered below-investment grade. Manager John Wiley has 17% of assets in bonds that carry the top rating of AAA. He avoids the shakiest issues. "There is no reason to reach for the weakest credits when you can get 5.5% yields with solid bonds," he says.

Another steady choice is

Ivy Municipal High Income

(IYICX) - Get Ivy Municipal High Income Fund C Report

, which has returned 5.7% annually during the past decade, outperforming 98% of competitors. The fund yields 5.1%. A sizable stake in AAA-rated bonds helped the fund beat its average competitor by 7 percentage points during the downturn of 2008.

Ivy manager Michael Walls focuses on issuers that provide essential services, including prisons and hospitals. Such bonds rarely default because their revenues are reliable. Walls stays away tobacco bonds, which are backed by revenues that cigarette companies pay to the states. The revenue stream could vary as sales of tobacco declines over the years. "We will never be big buyers of tobacco bonds because we trying to maintain a low-volatility portfolio," Walls says.

Delaware National High-Yield Municipal

(CXHYX) - Get Delaware National H/Y Muni A Report

returned 5.5% annually during the past 10 years, exceeding 95% of competitors. The fund yields 5.3%. Manager Stephen Czepiel avoided big losses in 2008 by buying general obligation bonds from top-rated states, including Georgia and Minnesota. The bonds proved relatively resilient because they are backed by the full taxing power of solid issuers.

These days the Delaware fund is selling some of its top-rated holdings and getting better yields by investing in lower-quality bonds from colleges and charter schools. "Now that the credit markets are improving, we are buying bonds with higher yields," Czepiel says.

Investors may want to divide their municipal holdings, putting half of the assets in a high-quality fund and half in a choice that holds high-yield bonds. That way the portfolio will have some extra yield and still remain relatively secure. High-yield bonds could prove particularly valuable this year because many economists expect that interest rates will rise. When rates rise, bond prices fall. But in periods of rising rates, low-quality funds tend to outperform because their high yields provide a cushion.

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