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.

Top-rated bonds were relatively resilient in recent months as nervous investors steered away from shaky issues. Although the average intermediate municipal portfolio has 15% of its assets in triple-A-rated securities, Baird has 68% of assets in the top-rated category. The approach is designed for conservative investors.

"Many municipal investors have made a lot of money, and they are focused on preserving wealth," says Baird portfolio manager Warren Pierson.

The cautious approach worked especially well in the turmoil of 2008. For the year, Baird returned 6.0% and outdid 99% of peers. The conservative stance does not win every year. In 2012, investors gained confidence and sought to obtain higher yields from low-quality bonds. For the year Baird lagged most peers.

Thornburg Intermediate outperformed this year by emphasizing bonds with shorter maturities. Those suffer only limited losses when rates rise. Early in the year, portfolio manager Christopher Ryon began shifting away from longer bonds because the yields seemed relatively skimpy.

"You were not being paid to take the risks of holding longer bonds," says Ryon.

Thornburg always holds bonds of different maturities, following a strategy known as laddering. The portfolio managers vary the ladder, sometimes emphasizing bonds of long or short maturities.

Now that yields on longer bonds have risen, Ryon has begun shopping again for bonds with maturities of 15 or 20 years. The laddering approach has proved effective in periods of rising and falling rates.

Waddell & Reed Municipal High Income fared relatively well this year by holding some adjustable-rate securities. Those stayed steady because their yields rise when interest rates climb.

The fund holds a mix of investment-grade bonds and securities that are rated below-investment grade. Portfolio manager Michael Walls says that the downturn has created special bargains in Puerto Rico.

The island suffers from big budget deficits and unfunded pension obligations. That has depressed bond prices. Walls says that investors have overreacted. He is picking up sound bonds that sell for as little as 60 cents on the dollar. His holdings include issues backed by revenues from electric utilities and sales taxes.

At the time of publication, Luxenberg had no positions in securities 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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