Excellent Municipal-Bond Funds

This article is part of Morningstar’s Guide to Income and Dividend Investing special report.

Municipal bond funds can fill an important role in an income-oriented yet tax-conscious investor's tool kit. Interest earned on muni bonds is generally free from federal income tax and may even be exempt from state and local taxes, depending on where you live. Munis therefore can provide tax advantages to those investors in the highest tax brackets.

Muni funds come in many flavors, catering to almost any income investor's needs. Some funds invest exclusively in shorter-, intermediate-, or long-term munis. Some focus on high-quality credits, while others focus on higher yielding (and lower rated) fare. Some are even dedicated to investing in bonds from particular states.

Eight muni funds receive Morningstar Analyst Ratings of Gold.

Four of those funds are managed by Fidelity:

"All of these funds take a relatively cautious approach that offers solid downside protection in rocky municipal-bond markets," says senior analyst Elizabeth Foos. The teams take a research-intensive approach, tapping into Fidelity's deep bench of muni-bond analysts and dedicated traders. The teams avoid interest-rate bets and instead tend to keep their durations close to their respective indexes. That said, they are willing to make some yield-curve plays, when opportunities arise. The main differences among these five funds is duration. In addition, while Municipal Income and Tax-Free Bond both invest in long-term securities, Tax-Free does not buy bonds subject to the Alternative Minimum Tax.

"The combination of solid long-term records, experienced teams, and low expenses earns them each a Morningstar Analyst Rating of Gold," she says.

T. Rowe Price oversees the other four Gold-rated muni funds:

Charlie Hill, who manages the intermediate and short-intermediate funds, looks for value along the yield curve, but doesn't make big interest-rate bets, notes Foos. Hill will, however, indulge in sector and security plays, employing a strategy that blends in-depth research with quantitative analysis. Summit Intermediate targets high-quality bonds in the one- to seven-year maturity range and can invest up to 10% of its assets in noninvestment-grade munis; it lands in Morningstar's Muni National Intermediate category. Short-Intermediate, meanwhile, sticks with investment-grade fare in the one- to six-year maturity range, landing in Morningstar's Muni National Short category.

Tax-Free Income, led by Dino Mallas, also eschews interest-rate plays, says Foos, and engages in thorough credit research, using the longer Bloomberg Barclays Municipal Bond Index as its benchmark. In addition, the fund doesn't invest in bonds subject to the AMT. It lands in Morningstar's Muni National Long category.

Tax-Free High Yield is the only muni fund focusing on lower-quality credits that earns a Gold rating. Manager Jim Murphy is cautious: He limits the fund's exposure to leveraged structures and avoids the market's riskiest names. Murphy also has the luxury of tapping into T. Rowe Price's experienced muni-bond research and quantitative teams. That research and restraint combined has helped blunt the high-yield muni market's sharper edges and providing solid long-term returns, says Foos.

Premium Members can access a complete list of Morningstar Medalist funds in the muni-bond group

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Silver-rated

"It offers broad exposure to investment-grade municipal bonds and is the cheapest fund in the muni national intermediate Morningstar Category,” notes analyst Phillip Yoo. The portfolio tracks the S&P National AMT-Free Municipal Bond index. “But its market-cap-weighting approach leads to a geographically concentrated portfolio, exposing the fund to state-specific risks,” adds Yoo.