Getting Fat Yields From Municipal Funds

NEW YORK ( TheStreet) -- Searching for income, investors have been pouring cash into high-yield municipal funds, which hold bonds that are rated below-investment grade. According to Morningstar, the tax-free funds yield 4.0%. That is the equivalent of a taxable bond with a yield of more than 6% for someone in the top tax bracket. In comparison, intermediate municipal funds -- which emphasize investment-grade bonds -- deliver tax-free yields of only 1.6%.

While low-quality municipals can be enticing, they come with considerable risk. During the market turmoil of 2008, high-yield municipal funds lost 25.3%, trailing intermediate funds by 23 percentage points. Because of the big losses, the high-yield funds rank as the worst-performing municipal category for the past five years.

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To get decent income without taking on much risk, many investors should consider those investment-grade funds that deliver above-average yields. The funds fatten their yields by holding big stakes in bonds rated A and BBB, the two lowest rankings in the investment-grade universe.

This strategy is different from the approach of typical investment-grade portfolios, which steer away from BBB bonds and focus on issues that are rated AAA and AA, the top two categories. While they yield 2 percentage points more than top-rated AAA issues, the BBB bonds have tiny default rates. Defaults should remain limited because many municipalities have reduced budget deficits in recent years by cutting payrolls and raising taxes.

Intermediate funds with above-average yields and strong long-term performance records include BlackRock Intermediate Municipal ( MEMTX), Commerce National Tax-Free Intermediate Bond ( CFNLX), USAA Tax Exempt Intermediate-Term ( USATX), and Vanguard High-Yield Tax-Exempt ( VWAHX).

A steady choice is USAA Tax Exempt Intermediate-Term, which yields 2.5%. During the past 10 years, USAA returned 5.0% annually, outdoing 85% of intermediate competitors. While the average intermediate fund has 63% of assets in bonds rated AA or AAA, USAA only has 32% in the top two grades. The average fund has 8% of assets in BBB bonds, compared to 27% for USAA.

"We manage our fund with an income focus, and a lot of times we have the highest yield available in the intermediate-term category," says portfolio manager Regina Shafer.

Part of the reason for USAA's competitive showing is the fund's relatively low costs. The portfolio has an expense ratio of 0.52%, compared to 0.83% for the average peer.

Among the top performers is Vanguard High-Yield Tax-Exempt, which yields 3.0%. During the past 10 years, the fund returned 5.2% annually, surpassing 92% of intermediate peers. True to Vanguard's reputation for low fees, the fund has a rock-bottom expense ratio of 0.20%.

Vanguard portfolio manager Mat Kiselak varies the credit quality of his portfolio as market conditions change. During 2008, he had 52% of assets in bonds rated AAA or AA. Now he has only 41% in the top two grades because lower-quality bonds seem to offer relatively cheap prices and rich yields. The fund has 51% of assets in bonds that are rated A and BBB.

A-rated health bonds yield about 120 basis points (1.2 percentage points) more than AAA bonds, Kiselak says.

"This is a time when you can get a significant yield pickup by looking at the A-rated bonds," he says.

Commerce National Tax-Free Intermediate often favors bonds from smaller issuers. Portfolio manager Brian Musielak says the second-tier issuers must pay higher yields to attract the attention of buyers. Lately Musielak has been finding bargains among bonds issued by smaller colleges and universities. He holds issues from two Chicago institutions, Columbia College and DePaul University.

"If you stay away from the well-known national universities, you can find good bargains in small issuers that have solid ratings," Musielak says.

Sticking with smaller issues, Commerce outpaced most competitors in 2008. The fund yields 2.5%. During the past 10 years, Commerce returned 5.0% annually, outdoing 86% of peers.

BlackRock Intermediate has 51% of assets in bonds rated A and BBB. The fund yields 2.4%. During the past 10 years, BlackRock returned 4.8% annually, outdoing 67% of peers. Peter Hayes, head of BlackRock's municipal department, favors hospital bonds. Before the financial crisis, many hospital bonds were rated AAA because they were backed by insurance. Now there is little insurance coverage available, and plenty of the bonds are rated A or lower. That has made investors wary and lowered prices of solid bonds, says Hayes.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.