Tax-Free Bonds Offer Tempting Yields

NEW YORK (TheStreet) -- As Washington struggled to sidestep the fiscal cliff last year, municipal funds sank. During December, the average intermediate tax-free fund lost 1.2%, according to Morningstar. Investors worried that Congress would undo some of the advantages of municipals. But since tax legislation passed on Jan. 1, the funds have gained back much lost ground.

The markets cheered the legislation because it did nothing to change the tax-exempt status of municipals. In addition, Congress raised the top tax bracket from 35.0% to 39.6%. That may be painful for high income earners, but it makes the tax exemption of municipal bonds more valuable.

To appreciate the impact of the tax rise, consider that the average intermediate-term municipal fund delivers a tax-free yield of 2.5%. In 2012, that yield was the equivalent of a taxable bond with a yield of 3.8% for investors in the top tax bracket. With top rates higher this year, the equivalent taxable yield has jumped to 4.1% -- a fat payout at a time when money-market funds yield almost nothing. "Demand for municipals has been strong because the yields are compelling," says Peter Hayes, who heads BlackRock's municipal group.

Even after their recent rally, municipal funds could continue climbing this year. Prices are still a bit depressed because of the uncertainty around the debt-ceiling negotiations, says Duane McAllister, portfolio manager of BMO Intermediate Tax-Free ( MITFX). Some investors worry that a final deal could limit tax advantages for high-income investors.

McAllister says that under normal circumstances, municipals should yield about the same or less than comparable U.S. Treasuries. But at the moment, 5-year AAA-rated municipals yield 0.87%, while 5-year Treasuries yield 0.78%. Nervous investors are demanding a premium before they will buy tax-free bonds. McAllister says that when Congress finally draws clear rules, prices of municipals could rise, and the yields would fall. "If we get beyond this uncertainty, there is room for municipals to do better," he says.

To take advantage of improving municipal markets, consider a fund with a record of steady performance. A top choice is BMO Intermediate Tax-Free, which returned 6.2% annually during the past five years, outdoing 96% of peers.

Portfolio manager Duane McAllister shined during the financial crisis by limiting his exposure to general obligation bonds, which are backed by the tax revenue of states and other issuers. As income and sales taxes dropped during the recession, GOs in Illinois and other states slumped.

McAllister has emphasized revenue bonds, which are backed by income from a single source, such as a sewer system or power producer. By sticking with reliable revenue sources, he outdid most peers in the turmoil of 2008 and 2009.

These days, BMO is beginning to shift back to GOs because income and property taxes are increasing as the economy recovers. "Half the states now have overall revenue that are above where they were before the recession," McAllister says.

Investors seeking a relatively high yield should consider USAA Tax Exempt Intermediate-Term ( USATX) , which yields 3.7%. During the past five years, the fund returned 5.6% annually, outdoing 83% of peers. Portfolio manager Regina Shafer boosts yields by holding a sizable stake in bonds rated BBB, the lowest investment-grade rating. "The lower-quality bonds have performed well as the economy has recovered," says Shafer.

She argues that the BBB bonds remain attractive because they yield considerably more than top-quality issues. A 15-year BBB bond yields 3.5%, compared to a yield of 2.1% for bonds that carry the top rating of AAA.

Another strong performer is Lord Abbett Intermediate Tax Free ( LISAX), which returned 6.0% annually during the past five years and outdid 91% of peers. Portfolio manager Dan Solender is keen on hospital issuers that have strong positions in their markets. "A lot of hospitals should thrive as the health sector evolves," he says.

Solender has bought some lower-quality issues. A favorite bond is a 15-year issue from Southwest Airlines ( LUV), which is rated BBB- and yields 3.9%.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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

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