High-Yield Muni-Bond Funds to Spice Up a Muni Portfolio

High-yield municipal-bond funds, just like taxable high-yield offerings, are best used around the margins of a portfolio rather than as core holdings. Although high-yield munis sport robust yields relative to higher-quality bonds, their increased credit sensitivity can translate into painful losses when the market craves quality. Moreover, the bonds can be illiquid, so if a fund manager has to unload credits to meet redemptions, he may have to sell at firesale prices. Such was the case in 2008, when the typical high-yield municipal fund lost a shocking 25% of its value

Used sparingly, however, a high-yield muni fund can provide a bit of extra oomph as a part of a well-diversified fixed-income portfolio anchored in high-quality credits. With an eye toward identifying some of the better options in this high-risk category, we turned to our  Premium Fund Screener to dig up high-yield muni offerings that have historically done a good job of keeping an eye on the downside. (Morningstar categorizes high-yield muni-bond funds as those that invest at least 50% of their assets in high-income municipal securities that are not rated or rated by a major rating agency at the level of BBB or below.)

To immediately streamline our findings, we kicked out all but the distinct portfolios of open, noninstitutional offerings with Morningstar analyses available. We then screened out funds with average credit ratings of less than BB and layered on a Morningstar risk screen to home in on funds whose risk scores are average or lower. Finally, we required that managers have helmed their funds for at least five years. When we eliminated funds whose fees were greater than the category average, six offerings remained, two of which we've highlighted below. Premium Members can replicate this screen by  clicking here.

 Franklin High Yield Tax-Free Income (FRHIX)
Managing downside risk is a priority for lead manager John Wiley. In addition to avoiding interest-rate bets, he also maintains a far higher-quality portfolio than most funds in the group. The fund's 50% stake in bonds rated A and above is almost twice as high as the category average, while Wiley holds just a third of his average peers' position in nonrated bonds. (Nonrated bonds are often lower-quality.) Moreover, he doesn't resort to leverage to bump up the fund's yield. The fund's straightforward and disciplined buy-and-hold approach has helped mute the fund's volatility relative to more assertively positioned peers. It didn't escape losses during 2008, when credit-sensitive munis as a whole suffered terrible declines, but its 17% drop was one of the smallest in the category. The fund will underperform its peers when low-quality credits fare best, but its experienced management and credit-research team give this offering an edge; low fees only add to this fund's appeal. The fund earns a "gold" rating in our new Analyst Ratings system.

 T. Rowe Price Tax-Free High-Yield (PRFHX)
Experienced manager Jim Murphy helms this fund and is flanked by eight muni credit analysts. To limit the damage that any one single credit can do to the portfolio, management diversifies the fund's assets across more than 400 issues. Although the portfolio's credit-quality breakdown doesn't stray far from the middle of the pack, Murphy avoids leverage and other techniques that could exacerbate volatility. Rather, as Morningstar analyst Miriam Sjoblom notes, he makes the most of the firm's research team to make measured portfolio decisions. Although the fund has not been immune to missteps in credit selection, and its 21.5% 2008 loss was painful, it's at the top of its class under Murphy's leadership over all long-term trailing time periods. Moreover, its below-average expense hurdle gives this offering a distinct advantage over its peers. Like the Franklin fund, it earns a gold rating.

Miriam Sjoblom contributed to this article.

A version of this article appeared on August 24, 2011.