In Hot Muni Sector, These Funds Get High Marks

Quick quiz: Among the U.S. stock, international-stock, taxable-bond, and municipal-bond fund categories, which one gained 13.1%--more than double the others--in the 12-month period ended Jan. 31? If you guessed muni-bond funds, you're right, and if you didn't, you might be surprised to hear just how strong the category has performed of late.

Munis' strong performance during the past year helped the category reverse a trend of fund outflows. In the first three quarters of 2011 investors pulled $22 billion from muni funds only to put nearly $10 billion back into them in the fourth quarter. The trend has continued in 2012, with a net inflow of $6.6 billion in January alone.

In addition to strong recent performance, muni bonds offer the potential for tax-free income, which makes them perfect for taxable accounts, especially for investors in higher tax brackets. The trade-off typically is a lower yield. But even with low yields, during the past year, those who have stuck with the category despite fears of potential defaults at the state and local levels have been well rewarded as a result of price appreciation.

However, don't let the past 12 months lull you into expecting long-term double-digit annual returns. During the past three-, five-, and 10-year periods, muni-bond funds have achieved annual returns of 8.01%, 4.57%, and 4.58%, respectively. That trails domestic-stock fund and taxable-bond fund performance in all but one case (domestic stock funds have gained just 0.91% on average during the past five years). Perhaps more importantly, current yields on munis are extremely low. One bellwether fund,  Vanguard Intermediate-Term Tax-Exempt (VWITX), currently has an SEC yield of just 1.82%. Because current yields typically provide a good indication of how bonds will perform in the future, this should prompt investors to keep their expectations in check.

The lesson here is be cautious with your expectations for muni bonds going forward. They continue to be a great option for some investors, but the current low-interest-rate environment should give any bond investor pause. Miriam Sjoblom, Morningstar's associate director of fixed-income analysis, talks about the outlook for munis in this video. To help you decide if munis are right for you, try Morningstar's Bond Calculator. (There's also a video here that shows you how to use it.) Factors to keep in mind include your current tax bracket and whether the fund you're looking at is exempt from state and local taxes where you live. Investing in a muni-bond fund for your state and qualifying for a possible tax break is a plus, of course, but it could spell trouble if your state runs into financial problems. National muni-bond funds, which provide diversification and protection against this danger, are often a better bet.

We recently used Morningstar's  Premium Fund Screener to help identify topnotch municipal-bond funds--no-load offerings with Morningstar Analyst Ratings of Gold or Silver that are available with minimum initial purchases of $10,000 or less. Premium users can click  here to run the screen themselves; here are three funds that made the cut.

 Fidelity Municipal Income (FHIGX)  
This fund takes a cautious approach--steering clear of excessive credit risk and leverage--that has allowed it to weather market turbulence better than most of its peers. During the past five years, the fund has returned 5.17% annually, ranking in the top quartile of the muni-national long-term bond category. The fund's managers tend to stick to higher-quality issues, reducing volatility and helping limit losses in down markets. The fund's $10,000 minimum investment is on the high side, but its 0.46% expense ratio is reasonable, especially for a fund backed by one of the industry's deepest muni credit analyst teams.

 T. Rowe Price Tax-Free Short-Intermediate (PRFSX)   (
)This fund's management team isn't afraid to take a calculated risk, betting on short-duration bonds its analysts think are underpriced. (Duration is a measure of interest-rate sensitivity.) Most of the fund's assets are rated at AA or better, providing an average level of credit risk with the chance for above-average returns. Manager Charlie Hill has led the fund since 1995 and is backed by a strong credit-research department. The fund's returns over the short and long term rank in or near the top one third of muni-bond short-term funds. Its minimum investment is $2,500, and fees are a low 0.49%.

 Vanguard Intermediate-Term Tax-Exempt (VWITX)  (
)With $34 billion in assets, this is not the most nimble fund around. But with a conservative, no-drama investing style concentrating on higher-quality issues while avoiding riskier ones, it makes a reliable core muni holding. The fund has performed better than average in recent market downturns and slightly worse than average during upturns. Its rock-bottom 0.20% expense ratio and $3,000 minimum investment make this fund enticing for anyone looking to play it safe cheaply.