Robert Amodeo, manager of the $4.1 billion

Legg Mason Partners Managed Municipals Fund

(SHMMX) - Get Report

, said essential service bonds offer the best rewards.

The fund, owned by

Legg Mason

(LM) - Get Report

, has rallied 14% this year, better than 83% of its competitors. Over five years, it has returned an annual average of 4%, beating 95% of rivals.

Welcome to's Fund Manager Five Spot

, where America's top mutual fund managers give their best stock picks in five fast and furious questions.

What is your outlook for the economy?


The second quarter should continue to offer mixed signals that would support the Fed's view that the recession is ebbing. We share that view, and it seems the market does as well. Equity indices have generated strong positive returns, and fixed-income spreads, notably investment-grade and high-yield debt, continue to moderate. It has been encouraging to see prices within these sectors move back toward fundamental valuations, as these were among the hardest-hit sectors during the downturn.

We believe that there will be further improvements ahead when and as evidence emerges that the worst is over and outright confidence returns. We recognize that there may be additional disruptions along the way, as we saw in February. There will be additional defaults, downgrades, tenders and restructurings, as well as more negative economic data. Nevertheless, we believe that the markets have begun to heal and that the probability of an extreme market downturn has lessened dramatically.

What is your favorite sector within the bond market?


Our portfolio management team is continually searching for undervalued bonds among various sectors. It is a relative-value-based philosophy that does not rely upon market timing or interest-rate forecasting. Any bond under consideration for investment will be valued as to where it should trade based on fundamental credit criteria, an evaluation of the prospects for its sector of the market, coupon, maturity, structure and liquidity.

During the recent past, risk-averse sentiment by investors toward all types of risks led to a historic cheapening of most investments, especially municipal bonds. We believe the current valuations offered by the municipal market may prove discounted beyond its fundamental challenges. Furthermore, the municipal market offers unique characteristics that can be very rewarding if managed properly. Municipal bonds also can provide valuable diversification to a broader investment program.

What is your favorite bond issue right now?


The dynamics of the municipal marketplace changed substantially during the past year. Looking ahead, investors will be well served by understanding the specific risks embedded within their bonds. The level of risk of a municipal bond is generally illustrated through various yield spreads including but not limited to geographic, sector, issuer and credit.

We've focused our recent efforts on securities with stable and broad revenue streams that should prove resilient during a challenging economic environment. Our favorite municipal issues are essential service bonds backed by revenues from water, sewer, transportation and utility projects. The risk versus reward relationship for this type of bond remains attractive to us, despite the rally that began in early 2009. Credit spreads are wide and the yield curve is steep.

Investors often prefer general obligations bonds during an economic downturn due to their taxing power. However, state and local government officials rarely have sufficient financial flexibility or political will to correct structural imbalances during challenging economic environments. Severe fiscal stress can surface quickly. Credit ratings become vulnerable and the probability of relative underperformance increases. Recently, revenue bonds backed by essential services have been an attractive alternative to tax-backed debt.

What type of bonds would you avoid?


It is difficult yet paramount during volatile environments to separate issuer strength from market liquidity. Moreover, we believe it is important for investors to remain positioned for the long-term trend in both interest rates and fundamentals and resist responding to short-term volatility in the market.

We try to create an information advantage through in-depth research. On a daily basis, we calculate average spreads for various sectors and issuers, as well as spreads within and between ratings and maturities. Divergences are studied to determine why they occurred and if there is an opportunity for these relationships to revert to the norm.

As mentioned previously, we currently are underweighting our holdings in general obligation debt. Additionally, we are avoiding bonds backed by the domestic sale of cigarettes. A significant decrease in domestic tobacco consumption and steady court challenges to the Master Settlement Agreement (MSA) and the tobacco companies themselves has led to weakening credit fundamentals. Our opinion may change at some point yet, at the moment, the risks to us outweigh the rewards.

Yields on U.S. Treasuries dropped to very low levels as investors viewed them as a safe harbor. The flight to Treasuries has made them more vulnerable than other sectors of the fixed-income market should the economic backdrop improve.

In the muni-market, what are you favorite and least favorite states?


Our focus remains centered around debt loads, structural deficits, depth and longevity of the current recession and access to capital markets. Most states and municipalities will have to reduce spending, increase taxes and tap into cash reserves, if available, to get through this challenging environment successfully. However, states cannot accumulate deficits when the economy turns sour and, for that reason, we have not yet issued an across-the-board directive to purge specific states.

On the other hand, investors must pay particular attention to state-specific challenges. The diversity of the respective economy and elasticity of tax receipts are key discussion points for us. As mentioned previously, we are concerned about structural imbalances, cash flow uncertainty, and the need for deficit financing and/or large non-recurring revenue streams. Specifically, we are not adding to credits that are overshadowed by those aspects, at yield levels with which we are uncomfortable.

California and Illinois both have a history of not reaching budget agreements in a timely manner. Each has resorted repeatedly to stop-gap measures. More importantly, these states rely heavily on continued access to the credit markets, even at a time when conditions might indicate otherwise. Florida is experiencing similar difficulties, but as a state with no income-tax requirements, it is more dependent on economically sensitive sales taxes and transaction fees.

Before joining, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.