By Ben Baden

Muni bond funds are currently offering unusually high yields

The past month has been rough for muni bond funds: Morningstar's intermediate municipal bond category lost 2 percent during that period as skittish investors pulled more than $7 billion out of all muni bond funds, according to the Investment Company Institute. Many cities and states are faced with rising budget deficits, and that has investors worried that some of them could default on their debt.

Those same concerns have pushed up muni bond yields, making them more attractive for different types of investors. Historically, muni bond funds have been primarily used by wealthy investors who purchase the bonds because they're able to take advantage of accompanying tax benefits. (Munis can be free from local, state, and federal taxes, depending on whether you're investing in bonds in your home state.) The downside is that munis typically yield much less than treasury bonds, so the bonds aren't beneficial for most investors in lower tax brackets because they don't generate as much income. That's changed as the U.S. economy continues to slog through a long stint of slow growth.

"Now, when yields are above treasuries and the taxable market overall, it can be a good deal for a much wider group of investors," says Miriam Sjoblom, Morningstar's associate director of fund analysis. "In general, this means you're getting this sort of tax-exemption kind of for free, so it's even more valuable when the yields are above treasury yields." She also attributes a lot of the recent volatility to an excess amount of supply (there have been a great deal of issuances in recent weeks.)

Investors can buy individual muni bonds, state-specific bond funds, or national muni bond funds, which hold bonds from throughout the country. The more diversified your holdings, the less vulnerable you are to a hiccup in a single bond or single area of the country, Sjoblom says.

With that in mind, here are U.S. News's best intermediate municipal bond funds for the long term (these funds are generally free from federal taxes and come with average durations of 4.5 to seven years.)

American Century Intemediate-Term Tax-Free Bond (symbol TWTIX)

Manager Steve Permut generally sticks to high-quality bonds. But currently, the fund holds some lower-quality issues because he believes they're undervalued. Permut's fairly conservative strategy has translated into steady performance over time. The fund generally doesn't lead in the rallies or lag in the downturns. Over the past 10 years, the fund has returned an annualized 5 percent. It yields 2.2 percent and charges annual fees of only 0.48 percent.

Marshall Intermediate Tax-Free (MITFX)

This fund differentiated itself from the pack in 2008 by finishing in positive territory while two-thirds of its peers lost money. Management is known for its cautious approach, and it recently diversified the fund into more holdings out of concern about credit trouble in the municipal bond market. Over the past 10 years, the fund has returned an annualized 5 percent. It yields 2.7 percent, and levies annual fees of 0.55 percent.

Invesco Tax-Free Intermediate (AITFX)

Management sticks to high-quality bonds. "What we're trying to do is complement riskier investments that other people have," says co-manager Richard Berry. He aims to keep the fund's average duration below the average of its peer group, which makes the fund less vulnerable to interest-rate hikes. The fund has returned an annualized 5 percent over the past 10 years. It yields 1.9 percent and charges annual fees of 0.38 percent.

Legg Mason Western Asset Intermediate-Term Muni (SBLTX)

The fund's managers aren't afraid to take on extra credit or interest-rate risk. They will also short -- or bet against -- treasuries at times to shorten the fund's duration. Currently, the fund is heavily weighted toward bonds with maturities of 10 years or more. In 2008, the fund finished near the bottom of its category because it loaded up on lower-quality bonds that didn't fare well, but it finished near the top of its category in 2009 when munis came roaring back. Over the past 10 years, the fund has returned an annualized 4 percent. It yields 3.4 percent and charges annual fees of 0.70 percent.

T. Rowe Price Summit Municipal Intermediate (PRSMX)

Manager Charlie Hill is known for taking a conservative approach to investing. The fund is highly diversified with more than 400 offerings, which is double the amount of its average peer, according to Morningstar. That diversification helped the fund finish in positive territory in 2008, but it has lagged somewhat since then. Hill keeps both interest-rate risk and credit risk low. The fund has returned an annualized 5 percent over the past 10 years. It yields 2.2 percent and charges 0.5 percent in annual fees.

Schwab Tax-Free Bond (SWNTX)

This fund was also able to finish 2008 in the black partly due to its focus on high-quality bonds. Management remained conservative in 2009. "[The] fund tended to favor high-quality revenue bonds, higher-rated hospital bonds, and securities in the essential services sector. The fund avoided land-based and tobacco bonds because of their higher credit risks," management said in the fund's semiannual report. The fund has returned an annualized 5 percent over the past 10 years. It yields 2.3 percent and comes with annual fees of 0.49 percent.

Dreyfus Intermediate Tax-Exempt Bond (DITEX)

The fund has seen some management shake-ups in recent years. In 2009, Steve Harvey replaced Doug Gaylor as manager of the fund.(He had previously been a co-manager.) Harvey won't take big credit risks, but he sometimes makes big sector bets. More than 2 percent of the fund's assets are in a 10-year California general-obligation bond. That's a fairly large single holding for a muni bond fund. Over the past 10 years, the fund has returned an annualized 4 percent. The fund yields 2.2 percent and comes with annual fees of 0.8 percent.

USAA Tax-Exempt Intemediate-Term (USATX)

Earlier this year, Regina Shafer replaced the fund's longtime manager Cliff Gladson. Shafer is a long-term investor who holds onto bonds she believes are mispriced. That can hurt the short-term returns of the fund, such as in 2008 when it lost more than 7 percent and finished near the bottom of its category. Since then, the fund has rallied. It returned 18 percent in 2009, and is up 4 percent year-to-date. Over the past 10 years, the fund has returned an annualized 5 percent. It yields 3.3 percent and charges annual fees of 0.47 percent.

Vanguard Intermediate-Term Tax Exempt (VWITX)

With more than $30 billion in assets, this is the largest municipal bond fund on the market. At times, it can be difficult for manager Michael Kobs to invest in smaller bonds because of the fund's ballooning size. Kobsinvests primarily in high-quality bonds. "As a result, the fund doesn't have to rely on leverage or lower-quality issues to compete, a trait that helped protect it in 2008's downturn," says Morningstar analyst Andrew Gogerty. The fund has returned an annualized 5 percent over the last 10 years. It currently yields 2.4 percent and charges annual fees of 0.20 percent.

Vanguard High-Yield Tax-Exempt (VWAHX)

The fund differs from the rest of the list because it's slightly titled toward high-yield muni bonds. Manager Chris Alwine can invest up to 20 percent of the fund's asset in high-yield -- or lower quality -- muni bonds. Alwine also takes larger interest-rate bets than his peers and invests in longer-maturity bonds that are more sensitive to interest-rate hikes. Over the past 10 years, the fund has returned an annualized 5 percent. It currently yields 3.5 percent and charges annual fees of 0.2 percent.

 

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