Municipal Bonds Land in Bargain Basement

NEW YORK ( TheStreet ) -- Most bonds have declined lately, but the damage has been particularly severe for municipal bonds and the mutual funds that invest in them.

This year mutual funds that invest in intermediate-term municipal bonds across the nation lost 3.5%, while funds that invest in high-yield municipal funds declined 7.4%, according to Morningstar. At the same time, the Barclays Capital U.S. Aggregate Bond index dropped 2.3%.

Now, however, some portfolio managers argue that municipals have reached attractive levels.

"We are seeing some prices that are comparable to what appeared during the financial crisis in 2008," says Michael Walls, portfolio manager of Waddell & Reed Municipal High Income ( UMUHX).

Walls says that municipals were not cheap at the beginning of the year. Then in the spring, prices collapsed and yields rose. Yields on triple-A-rated 30-year bonds have risen from around 3% early in the year to 4.6% now. The current tax-free yield is the equivalent of a taxable bond that yields 7% for high-income investors. Some bonds rated triple-B-minus, the lowest investment-grade rating, now yield 6.5%, up from 4.5% early in the year.

The big downturn began in May and June. After Federal Reserve Chairman Ben Bernanke talked about tapering his bond-buying program, investors started dumping bonds of all kinds. As prices fell, yields rose.

The rout in municipals became exacerbated by media reports that holders of Detroit bonds could face losses in bankruptcy proceedings. Panicked shareholders withdrew $31 billion from municipal mutual funds, a big sum for a fund category that has a total of $518 billion in assets.

"Retail investors looked at their monthly statements, and they started selling," says Walls of Waddell & Reed.

To capture attractive yields, consider mutual funds that fared relatively well during the downturn. Successful funds include Baird Intermediate Municipal Bond ( BMBSX), Thornburg Intermediate Municipal ( THIMX) and Waddell & Reed Municipal High Income. The winning managers emphasized short-term bonds or used other techniques to limit losses. Those approaches could protect shareholders in future downturns.

Baird Intermediate has lost 2.4% this year, outpacing average competitors by more than a percentage point. Baird often excels in downturns because it focuses on high-quality securities.

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