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Municipal Funds: Low Risk, High Return

Investors' interest is piqued as additional funds flow into state coffers from the federal economic stimulus program.

Municipal bond funds seldom enjoy representation on "best" lists because yields are sacrificed for lower taxes.

The adjoining table of the fixed-income mutual funds with the highest "overall" grades from ratings belies that notion.

Although muni-bond fund yields are invariably lower than their corporate and U.S. government counterparts of comparable maturities, tax-exempt offerings usually are less volatile. But that hasn't been the case during the credit crunch. Insured muni bonds experienced unusually wide swings in popularity as the credit ratings of bond insurance companies came under fire.

In addition, a legal threat to exemption of muni dividends to state taxes resulted in higher-than-normal price volatility until the controversy was resolved.

With those issues now behind them, muni bonds have recently been finding new friends, thanks to the prospect of huge inflows of additional funds flowing into state coffers from the federal economic stimulus program.

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Many of the funds on the list contain the highest possible marks of A-plus for their "risk grades" and "overall grades" from Ratings.

The grades can be interpreted as follows: A is "excellent" and considered a "buy" recommendation. B is "good" or "buy." C is "fair" or "hold." D is "weak" or "sell." And E is "very weak" or "sell." A plus or minus sign designates that a fund is in the top or bottom third of funds with the same letter grade.

Investors should be aware that a tradeoff always exists between risk and reward. Rarely will a fund be awarded a very high "performance" rating and, at the same time, a very high "risk" rating. On the contrary, low performance ratings and low risk ratings are more likely to go hand in hand.

Funds that have earned the highest "overall" investment ratings have attained an optimal combination of both primary components, while the lowest "overall" grades go to funds combining the worst possible risk and reward grades.

Richard Widows is a senior financial analyst for Ratings. Prior to joining, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.