Defensive Options for Muni-National Bond Investors

This year's credit meltdown has provided a pretty wild backdrop for muni-national bond funds. Bond prices have been hammered by a number of factors, including bond insurers' credit downgrades (or threats of downgrades) and muni hedge funds' en masse sales of their bond positions.

Even though interest rates are low, long-term funds have been hit the hardest: The typical fund in the category is down 4.9% for the year to date through Sept. 29, 2008. For that time frame, the typical intermediate-term fund is down 3.9% while the typical short-term offering has lost 1.6%. We'd note that much of the pain has come in the past two weeks, and it has been nearly a decade since any of the categories was in the red for a calendar year. (In 1999, the national intermediate-term category was down 2.1% while the national long-term category fell 4.7%.)

Amid all this bad news, we think there's a silver lining for muni investors. Falling bond prices mean that many managers are finding interesting opportunities. Plus, many muni-bond funds currently offer attractive taxable-equivalent yields even for investors in lower tax brackets. These fatter yields make it an even more interesting time to buy in. We'd add a word of warning, though. Given the extreme volatility and liquidity crunch in the muni markets recently, there is certainly the possibility that muni issues will continue to be punished in the near term. So, those who invest in these funds should make sure they have a long enough time horizon to withstand a few bumps in coming months.

We used the  Premium Screener to zero in on some of our favorites in each of the above muni-bond categories. (Don't have a Premium Membership? You can still use our Premium Fund Screener by taking a free, 14-day trial.) In doing so, we required that the funds fall in the top third of their category's performance ranking for the trailing 10-year period, as well as a top-third showing so far in 2008. And as per our usual, we limited the list to open funds with below-average fees and investment minimums at or below $25,000.

The screen returned the following results as of Sept. 29, 2008. To run the screen for yourself,  click here.

Muni-National Short
 Fidelity Short-Intermediate Muni Income (FSTFX)
 USAA Tax Exempt Short-Term (USSTX)

Muni-National Intermediate
 American Century Tax-Free Bond (TWTIX)
 Fidelity Intermediate Municipal Income (FLTMX)

Muni-National Long
 Delaware Tax-Free USA (DMTFX)
 Fidelity Advisor Municipal Income 
 Fidelity Municipal Income (FHIGX)
 Legg Mason Partners Managed Municipals (SHMMX)
 T. Rowe Price Tax-Free Income (PRTAX)
 Thrivent Municipal Bond (AAMBX)
 Vanguard Long-Term Tax-Exempt (VWLTX)
 Wells Fargo Advantage Municipal Bond 

We'd note that screening without the aforementioned expense ratio criteria did not alter the final results. That's because high-cost bond funds tend to underperform over the long term. A lower fee hurdle allows a fund manager to take fewer credit and interest-rate risks in order to deliver yield and return to shareholders.

It's also worth noting that most of the funds on the list above are run by experienced managers who often work with sizeable teams of credit analysts. Depending on your return expectations and time horizon, we think that these funds are worthy of consideration.