Municipal Funds That Pay Rich Yields

NEW YORK ( TheStreet ) -- With the Federal Reserve keeping a lid on interest rates, 10-year Treasuries yield a skimpy 1.75%. For a better payout, consider high-yield municipal funds.

According to Morningstar, the average fund in the category yields 4.2% tax-free. That is the equivalent of a taxable bond that yields more than 7% for high-income investors.

Make no mistake, high-yield municipals are riskier than Treasuries. But at a time when municipal finances are strengthening, the high-yield funds should produce reliable income.

The high-yield funds invest in tax-free debt from states, cities and other issuers. The high-yield municipal funds should not be confused with the better-known high-yield bond funds, which hold taxable corporate bonds. The taxable funds invest almost exclusively in junk bonds that are rated below-investment grade. The junk securities pose clear risks of default. In 2012, 2.6% of junk issues defaulted, according to Moody's. The historical average default rate is 4.8%.

In contrast, only a handful of municipal issuers default every year. In 2012, five of the approximately 50,000 issuers defaulted.

High-yield municipal funds limit their risk by diversifying portfolios and holding some high-quality bonds. The typical fund has about one third of assets in bonds that are rated below-investment grade or unrated. Another third are in securities rated BBB, the lowest category of investment-grade issues. A final third are rated A or higher. Because they hold some high-quality issues, high-yield municipal funds tend to be less volatile than their high-yield corporate counterparts.

During the turmoil of 2008, high-yield municipals suffered painful losses. Since then the funds have been rallying as investors have grown more willing to take risks in search of higher yields.

In recent months, municipals received a boost from the changes in tax rates. With the expiration of the Bush tax cuts, the top bracket rose from 35% to 39.6%. That made the tax shelter of municipals more valuable and boosted demand for the bonds. During the past year, high-yield municipal funds returned 10.4%, compared to 3.9% for the Barclays Capital U.S. Aggregate bond index.

Among the top-performing high-yield funds is Ivy Municipal High Income ( IYIAX). During the past five years, the fund returned 8.1% annually, compared to 5.7% for the average peer. In the turmoil of 2008, Ivy lost 18.1%. That was a miserable result, but it outpaced peers by eight percentage points.

Portfolio manager Michael Walls limited losses by taking a defensive stance. Walls became cautious as early as 2006, a time when municipal markets were climbing. "We thought municipals were getting hot, and prices were rich," he says.

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