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Municipal Funds Veer From Safety to Danger

A massive disparity in performance shows why investors ought to understand funds' holdings.

The credit crisis has clobbered most bonds. But the damage is especially notable in municipal markets. During the 12 months ending in November, municipal long-term funds lost 9.1% of their value, according to Morningstar. High-yield municipal funds dropped 20.4%.

What makes the losses so unsettling is that tax-free bonds normally seem stodgy. Because many of them are backed by tax revenues, municipals rank as the second-safest category behind Treasuries.

Most often, municipal funds grind out single-digit returns. Only a percentage point or so often separates the top performers in the category from also-rans. This year, returns were all over the map, ranging from single-digit gains to losses of more than 30%.

The big disparities occurred because the markets punished some sectors more than others. While high-quality bonds proved relatively resilient, shakier issues sank. At the same time, investors dumped long bonds and fled to short issues. In addition, some funds were weighed down by investments in inverse floaters and other derivatives, which collapsed in the market panic.

Investors did best in plain-vanilla funds that focus on quality short-term issues. Among the winners was

Vanguard Short-term Tax Exempt

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, which returned 3.8% for the 12 months. At the other end of the spectrum was

Rochester National Municipal

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, which owned derivatives and low-quality issues, holdings that caused the fund to lose 40.6%.

The varying results demonstrate why investors should understand what their municipal funds hold. In a sector that can seem blandly homogenous, portfolio managers follow different strategies. Investors who have suffered big losses should re-evaluate their holdings and consider funds that now seem poised to deliver winning results when the markets revive.

To prepare for a rebound, consider

Eaton Vance National Municipals

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. The fund's portfolio has an average maturity of 25 years, one of the longest of any fund. In contrast, the average long municipal fund has an average maturity of 15 years.

Portfolio manager Tom Metzold favors long bonds because they yield more than short issues. He typically buys securities rated A or higher by Standard & Poor's, and holds the bonds for years. The strategy worked beautifully from 2002 through 2006 when Eaton Vance outdid 99% of its competitors.

Then, beginning in 2007, trouble appeared as hedge funds and other investors sold municipals to raise cash for margin calls. Much of the selling involved long bonds, and their prices sank. When bond prices fall, yields rise.

Now the yield gap between short and long municipals is unusually wide. According to Bloomberg, the yield on 2-year AAA-rated general obligation municipals is 2.02%, compared to 5.62% for 20-year bonds. By that measure, long bonds are extremely cheap, says Metzold. "When the markets return to normal, long bonds should outperform," he says.

If long bonds climb, another choice that should outdo peers is

Thornburg Intermediate Municipal

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. The fund's portfolio has a maturity of 8.4 years, almost the same as the average intermediate municipal fund. But Thornburg follows a distinctive approach.

While most intermediate funds focus on bonds with maturities of 5 to 15 years, Thornburg uses a method known as laddering. In a typical ladder, an investor buys bonds with maturities of one year, two years, three years and so on. Thornburg holds maturities up to 18 years. If prices of the long issues climb, the fund will beat competitors that hold only intermediate bonds.

To maintain its ladder, Thornburg does little trading. Instead, the fund typically buys long bonds and holds them until they mature. Then the fund takes the principal from the matured bonds and reinvests in more long issues.

In today's market, Thornburg is able to put its cash to work in high-yielding long bonds. That provides an edge over funds focused on shorter maturities. "We have a steady source of cash that is enabling us to buy attractive bonds," says portfolio manager Christopher Ihlefeld.

No matter how markets fare going forward, one of the top performers is likely to be

Vanguard Intermediate-Term Tax Exempt

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. In up and down years, the fund has usually finished in the top half of its category. The success is due to Vanguard's customary low fees.

While rock-bottom expenses benefit all Vanguard funds, costs are particularly important for municipal portfolios because the yields and returns in the category are relatively low. Consider that during the past decade, Vanguard Intermediate-Term has returned 3.8% annually, compared to 3.3% for its average peer. That gap can be explained by fees, because Vanguard charges a tiny expense ratio of 0.15%, compared with 0.92% for its average competitor.

High costs can be a special drag for bond funds because the fees are subtracted directly from yields. To compensate for their hefty expenses, some funds own riskier bonds that offer higher yields. But Vanguard Intermediate-Term has no reason to dabble with shaky bonds or complicated trading strategies.

Instead, the fund keeps most of its assets in bonds rated AA or AAA. That cautious approach helped protect shareholders this year and should continue generating competitive results when calm returns to the bond markets.

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