High-Yield Municipals Look Set to Rise

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The credit crunch has slammed corporate junk bonds and bank loans. But of the 30 fixed-income categories monitored by fund tracker Morningstar, high-yield municipal funds rank dead last for the 12 months through July 15, losing 5.33%. In contrast, intermediate municipal funds gained 4.19%, and long government funds returned 15.23%.

Now there are good reasons to expect that high-yield municipals can rebound and outperform most bond classes in the next year.

Many high-yield bonds look cheap compared to alternatives. When bond prices fall, yields rise, and that has occurred in tax-free markets. High-yield muni funds that yielded less than 5% a year ago now yield 6.0% or more. That is the equivalent of a taxable bond yielding 8.3% for an investor in the 28% tax bracket. The rich yields on the funds seem particularly appealing at a time when 10-year Treasuries pay 3.8%.

High-yield funds -- which focus on bonds rated below investment-grade -- yield about a percentage point more than intermediate municipal funds with investment-grade ratings. That is a wider spread than normal and a big change from a year ago, when the gap was only 25 basis points, or one-quarter of a percentage point.

"Last year, high-yield bonds looked expensive, and now they seem cheap compared to other municipals," says Mark Otterstrom, portfolio manager of Waddell & Reed Municipal High Income (UMUHX).

Besides paying fat yields, high-yield munis seem like relatively stable investment vehicles, says Timothy Pynchon, portfolio manager of Pioneer High Income Municipal Fund (PIMAX).

"The balance sheets of most hospitals and other issuers look fine," says Pynchon.

While some investors compare high-yield municipals to corporate bonds, the two groups are very different. The typical junk corporate bond depends on revenue from a business. During recessions, the number of corporate bankruptcies can climb sharply. In contrast, many tax-free bonds are backed by municipalities, which rarely go bankrupt and almost never disappear.

On average, about 4% of all corporate junk bonds default every year. But municipal default rates tend to be much lower. Studying the performance of municipal bonds over a 22-year period, Standard & Poor's found that of bonds rated BB -- one rung below investment grade -- the number of defaults amounted to only 1.47% of total issues.

High-yield corporate funds are also significantly different than their muni counterparts. Shakier bonds pay higher yields, and many corporate funds reach down for lower-quality credits. Typical corporate high-yield funds emphasize bonds rated B, two steps down the credit ladder from investment grade. Many muni funds take a more cautious approach, holding some stakes in bonds rated BBB, the lowest investment-grade rating.

Partly because of the more conservative stance, high-yield muni funds tend to be less volatile than their corporate competitors as measured by standard deviation, an indication of how much investments bounce up and down.

Despite their relative stability, muni bonds suffered badly as the credit crisis unfolded. Much of the trouble had its roots in trading by hedge funds and other big players last year. In a popular leveraged trade, a hedge fund would buy long-term municipal bonds yielding 4.5%. To finance the transaction, the fund would sell short-term debt, yielding 1.5%, to money market funds. To attract money markets, hedge funds bought coverage for the short-term debt from insurance companies such as Ambac (ABK) and MBIA (MBI).

Even after paying for insurance and financing, hedge funds earned a tidy profit from the interest on their municipal portfolios.

Then last summer trouble appeared. Some hedge funds began selling municipal bonds in order to cover their losses in mortgage markets. As problems appeared with bond insurance companies, money markets stopped buying short-term debt from hedge funds. That halted the leveraged purchases of munis.

The problems culminated in February, when big investors dumped municipals wholesale. High-yield funds lost 5.6%, their worst monthly performance since 1980.

"Unusual circumstances came together and hurt municipals," says Geoffrey Schecter, portfolio manager of MFS Municipal High-Income (MMHYX).

The downturn pounded investment-grade and high-yield munis alike. But in recent months, high-grade munis have recovered sharply. High-yield bonds have been slower to rebound, as investors have been wary of taking on extra risk.

Still, the odds seem good that lower-quality munis will enjoy a strong year. Since 1981, high-yield muni funds have never suffered two losing years in a row. Most often, downturns have been followed by healthy rallies. For example, the funds lost 4.6% in 1994, when interest rates rose. The following year, the high-yield muni funds came roaring back, returning 16.3%.

A similar performance is not impossible this year. The default rate for high-yield municipals remains tiny. Leveraged trading no longer roils the tax-free markets. And the election could boost muni prices. Democrats are promising to raise taxes. That would increase the tax advantage of munis, encouraging investors to bid up bond prices.

For the moment, demand for high-yield munis is muted. Wounded hedge funds are sitting on the sidelines. But agile investors can gain an edge by buying high-yield funds while they are still at bargain prices.

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