NEW YORK (
) -- Tired of puny money-market yields, investors have been pouring money into municipal mutual funds. During the first 11 months of 2009, $64 billion flowed into tax-free funds, a huge surge for a category that only has $450 billion in total assets, according to the Investment Company Institute.
All the buying has pushed up bond prices. That has helped the average intermediate municipal fund return 9.7% during the past year, according to Morningstar. After the rally, have municipals become too rich? Not necessarily. Analysts say some municipals still sell at attractive prices.
Municipals typically yield from 70% to 90% on the rate of Treasuries. Investors accept the lower yields because income from municipals can't be taxed by Washington.
During the fourth quarter of 2008, the traditional patterns went haywire. Panicked Investors dumped municipals and raced to buy Treasuries. By January 2009, 30-year Treasuries yielded 3%. Many municipals yielded 200% of the Treasury rate, an unprecedented event that occurred because frightened investors were demanding outlandish yields before they would take the risk of owning tax-free bonds. Since then, investors have reversed course, favoring municipals.
Not all municipals have participated equally in the rally, says Dan Solender, manager of
Lord Abbett Intermediate Tax-Free
. Some of the best remaining values are long bonds, he says. Prices of 30-year bonds are still soft, since investors worry about the long-term prospects of the bond markets.
The average 30-year AAA-rated municipal currently yields 4.5%, about 95% of the rate on comparable Treasuries. For investors in the 28% tax bracket, the long municipal yield is the equivalent of a taxable bond yield of 6.2%.
After presenting screaming bargains in 2008, intermediate municipals are now fairly priced, Solendar says, with 10-year municipals yielding 3.3%, or 86% of the Treasury rate. Short bonds look expensive. With investors seeking the safety of short-term securities, two-year municipals only yield 0.6%, or 64% of the comparable Treasury rate.
Prices of all kinds of municipals could improve if taxes rise next year, as analysts expect. Say the top tax rate climbs from the current 35% to 40%. More high-income investors would scramble to buy municipals, pushing up prices. "If Congress raises taxes, then the tax advantage of municipals will become more valuable," Solender says.
To try municipals, conservative investors could consider Lord Abbett Intermediate, which has returned 4% annually during the past five years, outdoing 88% of its peers. The fund has two-thirds of its assets in bonds rated AAA and AA, Standard & Poor's top grades. High-quality bonds helped the fund outperform most competitors during the downturn in 2008.
Solender overweights segments of the bond market that appear to represent the best values. At the moment, he's leaning away from short-term bonds and emphasizing securities with maturities of eight to 10 years.
Another cautious fund is
Waddell & Reed Municipal Bond
. Manager Bryan Bailey aims to outperform in downturns and get decent results in bull markets. Most often he's succeeded. Bailey began growing concerned during the rising markets of 2005. At the time, confident investors were straining to get more yield, bidding up prices of lower-quality issues.
To avoid trouble, Bailey shifted away from bonds rated BBB, the lowest rung in the investment-grade universe, and began emphasizing top-quality bonds. "I could not believe that the market could sustain the lower-quality prices that we were seeing," he says.
For two years, Waddell & Reed trailed many competitors. But the caution paid off when the market came unglued in 2007 and 2008, and lower-quality bonds collapsed. By limiting losses in the bad times, Waddell has returned 4.1% annually during the past five years, beating 91% of its peers.
A broadly diversified choice is
Thornburg Intermediate Municipal
, which has returned 3.6% annually during the past five years, surpassing 60% of peers. The fund follows a strategy known as laddering. Manager George Strickland holds bonds with maturities of one year, two years, three years and so on up to 18 years. When a bond matures, Strickland typically takes the cash and buys a new 18-year bond. Then he holds that bond until it matures.
Longer bonds tend to yield more than shorter ones. Because Thornburg is constantly buying 18-year bonds, the fund outyields competitors that stick with shorter bonds. Thornburg currently yields 4%, 0.6 percentage point more than the average intermediate municipal fund.
The laddering strategy doesn't work every year. During the market collapse, Thornburg trailed its average competitor as investors shied away from longer bonds. But in 2009, Thornburg came roaring back, returning 13.7% and outdoing its average peer by two percentage points.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.