Worthy Muni Bond Funds That Deserve a Look

Municipal bonds have struggled recently, owing to concerns about a spike in new issuance and worries over state and local municipalities' financial health. That performance hiccup was followed by a record outflow of cash from municipal-bond funds in recent weeks.

But as much as cash-strapped state and local municipalities are the sobering reality, it behooves investors to tune out some of the noise before fleeing munis altogether. Worried investors should keep in mind that large-scale muni defaults are unlikely, and income-oriented investors can still find some worthwhile municipal offerings. Moreover, with tax rates on the highest earners set to go up in 2011, barring congressional action, the case for munis for wealthier investors becomes even stronger.

One way to mute issuer-specific risks is to invest in a mutual fund that invests in high-quality bonds from throughout the United States. No muni bond fund offers a completely risk-free place to park your cash, but we used the  Premium Fund Screener to call up a list of worthy national intermediate-term municipal core offerings that keep a lid on risk.

To streamline our results from the get-go, we asked for only distinct portfolios of funds that were open to new investments of $10,000 or less. We then looked for only no-load funds in the category's cheapest quartile. We also applied a stress-test for performance by eliminating funds that did not rank in the top third of their peer groups for five- and 10-year returns. To further control for risk, we screened for funds with a Morningstar risk score of average and below. The screener yielded eight funds, three of which we highlight below. To replicate this screen, Premium members can  click here.

 Fidelity Intermediate Municipal Income (FLTMX)
Manager Mark Sommer prioritizes safety by sticking to high-quality issues and avoiding interest-rate bets, but he also seizes on opportunities to find undervalued securities. During the past few years, for example, he has gradually added attractively valued longer-dated securities as well as purchased some midgrade bonds in the health-care sector. All in all, this Analyst Pick's excellent strong risk controls, relatively low costs, and topnotch research team are points in its favor; it merits investor consideration as a core muni holding.

 Vanguard Intermediate-Term Tax-Exempt (VWITX)
Although the fund's sizable asset base limits its agility, the fund has the advantage of being broadly diversified. And by sticking to high-quality AAA and AA bonds and limiting exposure to below-investment-grade securities, the fund minimizes credit risk. This strategy helped shield the fund in 2008's downturn when funds with stakes in lower-quality issues were hit. The fund also sports an attractive price tag--its 0.20% expense ratio puts this fund among the category's cheapest. Furthermore, while analyst Andrew Gogerty notes that the fund's modest duration bets haven't always worked in its favor, its measured investment approach and its competitive yield and return give this fund strong appeal.

 Marshall Intermediate Tax-Free 
Investors can rest assured that this fund is unlikely to be taking much risk. During the turmoil of 2008, managers John Boritzke and Duane McAllister kept credit quality on the high side and avoided the volatile airline and tobacco sectors, which helped shield this fund from the huge losses that some of their peers suffered. But just because the managers avoid risk doesn't mean they can't spot bargains. Management jumped on the opportunity to purchase some downtrodden A and BBB bonds coming into 2009 because they felt that they were being compensated for the risks of those bonds, a move that kept the fund ahead of its peers during the 2009 muni market rebound. Although the fund might lag when the market favors riskier assets, investors seeking a dependable, low-volatility offering with an excellent track record to boot will find that the fund fits the bill.