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Investing Specialists

Is It Time to Buy American's Muni-Bond Funds?

These funds pack plenty of appeal right now.

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This month, I'm taking a look at a small corner of the American Funds lineup: Its municipal bond funds. Although these five funds-- Tax-Exempt Bond (AFTEX),  High-Income Municipal Bond (AMHIX),  Tax-Exempt Fund of California  (TAFTX), Tax-Exempt Fund of Maryland (TMMDX), and Tax-Exempt Fund of Virginia (TFVAX)--comprise just 1% of American Funds' assets among them, they deserve attention from investors looking for bond funds in their taxable accounts. Not only do these funds have substantial, fundamental merits (more on that below), but they represent potential buying opportunities right now.

Muni bonds had a subpar year in 2007. As subprime mortgages imploded, a liquidity crunch ensued. Also, hedge funds and others that had made leveraged bets on muni bonds and then hedged those bets by shorting Treasuries, got stuck when Treasury bonds' prices rose as investors fled to "quality" in the wake of the credit crunch. To cover their shorts, the funds sold some of their muni-bond holdings, thus driving those bonds' prices down and their yields up. Also, investors became concerned about the potential for declining tax revenues from housing and the financial health of bond insurers (a number of muni bonds are insured). As a result, the typical muni national intermediate-term fund (the most common type) gained just 2.7% in 2007. And they haven't looked any better in 2008: For the year to date through Feb. 12, the typical fund in that category has gained only 0.29%.

Perhaps more importantly, yields for higher-rated muni bonds now rival those of high-rated taxable bonds. That means munis are currently a better deal in a taxable account than taxable bonds--even for investors in low tax brackets. That's rather unusual. For example, the 10-year Treasury bond sported a yield of 3.5% as of Feb. 12, 2008--slightly lower than the 3.61% yield of a 10-year AAA rated municipal bond. An investor in, say, the 28% tax bracket would earn a tax-equivalent yield of 5.01% on a 10-year muni bond.

How Have American's Options Fared?
As for American's muni-bond funds, most had a particularly poor 2007. That's because the four funds other than High-Income Municipal often take on more credit risk than their typical category rivals, which hurt when investors turned to higher-rated bonds. (Indeed, each of the four funds landed in the bottom third of its category.) However, I like the fact that these funds harness American's long-term strengths--credit research performed by a large analyst staff. What's more, the funds are quite reasonably priced relative to other broker-sold options; each is cheaper than 80% of its front-load rivals.

Below, I take a closer look at each of the five funds and how they stack up against prominent broker-sold rivals.

Tax-Exempt Bond
The flagship of American's muni-bond fund lineup, this offering doesn't shy away from taking on credit risk. It recently held a 21% stake in bonds rated BBB or below, compared with the group norm of 13%--and that's after the fund's managers had trimmed their bets on lower-rated fare. As a result, the fund looked quite sluggish versus its muni-national intermediate peers last year, but that showing was preceded by four straight years in the category's top decile, and its long-term record is stellar. The fund's three managers, who run separate portfolios, are backed here by four credit analysts and expect to have two more analysts supporting them in the near future. Furthermore, the fund's 0.54% expense ratio is roughly one fourth lower than the price tags of its three largest broker-sold rivals-- Columbia Intermediate Municipal Bond (LITAX), JPMorgan Intermediate Tax-Free Bond (JITAX) and  Nuveen Intermediate Duration Municipal Bond (NMBAX). Costs are particularly important with muni funds, because muni-bond yields are typically low on an absolute basis relative to their taxable counterparts. (It's worth noting that the Analyst Picks in the categories in which American's muni funds reside are all no-load, low-cost funds.)

The fund's three biggest broker-sold rivals all take on less credit risk, generally. However, this fund has also been judicious in the risks it takes. For example, in 2002--the last time lower-quality debt lagged--the fund tread lightly among hard-hit airline and corporate bonds. And recently, management has limited its stake in tobacco bonds to 5%. The fund considers all bonds related to tobacco's master settlement as coming from one issuer, even though they're issued on different states. It's this mix of aggressiveness and caution that has resulted in the fund outpacing all three of its largest broker-sold rivals over the decade ending Dec. 31, 2007. I think it's a solid choice (arguably more attractive than its three rivals), and muni bonds' relatively high current yields make this a good time to consider the fund.

High-Income Municipal Bond
While American's other muni funds take on more credit risk than many of their category peers, this fund sometimes takes a tamer approach than its typical high-yield muni rival. Its managers have become cautious about lower-rated bonds' prospects too early at times--witness the fund's struggles from 2004-06 as high-yield led the way--but the fund has held up quite well in tougher times, such as 2007. Its typical rival registered a loss of more than 3% last year, but this fund lost less than 1%. The managers don't always play it safe, though: In the late 1990s, the fund had an above-average stake in lower-quality debt, which boosted returns. All told, it has outpaced three quarters of its rivals over the past decade.

This fund is a bit more expensive than two of its three biggest broker-sold rivals-- Franklin High-Yield Tax-Free Income (FRHIX),  Goldman Sachs High Yield Muni (GHYAX), and  Oppenheimer Rochester National Muni (ORNAX)--but that's understandable, given the fund's smaller asset base. Franklin's fund has consistently been more conservative than American's, but the other two have generally taken on more risk. American's is an appealing option. The Oppenheimer fund sports a stellar record, but its big stakes in tobacco and airline bonds have made for a bumpy ride. The Franklin fund's conservatism is appealing, and it's outpaced the American fund by an annualized 1 percentage point. Finally, the Goldman fund is expensive, and it has a shorter track record that was marred by a very poor 2007.

Tax-Exempt Fund of California
This fund, along with American's other muni funds that focus on a single state, takes essentially the same approach as Tax-Exempt Bond: It attempts to gain an edge by taking on more credit risk and doing a better job of analyzing such issues. That strategy has met with similar results here. The fund struggled mightily in 2007 relative to its municipal California intermediate/short-term rivals due to its lower-rated holdings, but it has generated excellent returns over the long haul. What's more, the fund is the cheapest broker-sold option in the category that sports an intermediate-term profile. (A few short-term funds are cheaper.) Compared with each of its three largest front-load competitors with similar sensitivity to interest-rate shifts--Columbia California Intermediate Municipal Bond (NACMX),  Franklin California Intermediate-Term Tax-Free Income (FKCIX), and SEI Tax-Exempt California Municipal Bond (SBDAX)--American's fund invests more heavily in lower-quality debt. It also has outpaced each one over the past five years. (The three rivals lack a 10-year record.) I think this fund is the best of the bunch, and it's the strongest broker-sold option in the category that Morningstar actively follows.

Tax-Exempt Fund of Maryland, Tax-Exempt Fund of Virginia
These two funds reside in Morningstar's broad, single-state muni fund category, where we place funds that have few rivals that focus on the same state. American's Maryland fund has just three front-load competitors with relatively long histories, and it takes more credit risk than all of them. It's also cheaper than the other three, and it has beaten each one over the five- and 10-year periods ended Jan. 31, 2007, so I think it's a very fine choice. The Virginia fund is less appealing: Its expense ratio is merely average relative to its six front-load rivals that invest in that state, as are the fund's long-term results. Thus, I think investors can do better elsewhere, particularly in  T. Rowe Price Virginia Tax-Free Bond (PRVAX)

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Greg Carlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.