Smaller Muni Funds That Do Their Homework

In last week's Five-Star Investor we looked at smaller taxable-bond funds that Morningstar's fund analyst team likes. This week we turn to municipal-bond funds.

For the uninitiated, municipal-bond funds invest in debt issued by state or local governments or agencies. One major advantage of munis, and a source of their appeal for investors in higher tax brackets, is that income from them is not taxed at the federal level. In addition, investors who buy bonds issued by municipalities in their home states might also be able to avoid state and local taxes on the bonds' income. For a discussion of whether municipal bonds are right for your portfolio, click here. 

Although generally considered among the safest of asset classes, munis are hardly risk-free. In just the past month three California municipalities--Stockton, Mammoth Lakes, and, last week, San Bernardino--have declared bankruptcy. Last October, Harrisburg, Pa., filed for bankruptcy. Even though these recent cases might give some muni investors pause, Morningstar's municipal credit analysts do not foresee a significant increase in the rate of municipal bankruptcies, as senior securities analyst Dave Sekera discusses in this Bond Strategist article. These bankruptcies do, however, serve as a reminder of the importance of credit analysis in bond-picking, Sekera points out. And though associate director of fund analysis Miriam Sjoblom warns that munis' recently strong gains may not continue, the prospect of higher income tax rates set to take into effect in 2013, as well as the new Medicare surtax, could push up demand for munis.

One of the great things about being a fund investor is that you get to rely on the pros to do the heavy lifting when it comes to analyzing munis. Sticking with municipal-bond funds with experienced, knowledgeable managers backed by quality research teams can help minimize the chances of a rare default showing up in your portfolio. As with taxable-bond funds, there are many quality muni-bond funds run by fund families large and small, and occasionally some of the better funds don't get the attention they deserve.

To identify some of these funds, we used our  Premium Fund Screener and searched for funds with Morningstar Analyst Ratings of Bronze or better that invest in national short, intermediate, and long muni bonds, as well as high-yield munis. We excluded muni funds targeted at investors in specific states because of their limited appeal and kept funds with asset bases of less than $5 billion. Finally, we stuck with no-load funds with minimum investments of $10,000 or less. Premium users can click  here for the full screen. Below are a few of the funds on our list.

 T. Rowe Price Tax-Free Short-Intermediate (PRFSX)
Assets: $1.8 billion
This fund relies on its strong credit-analysis team to identify incrementally higher-yielding bonds whose fundamentals appear better than their prices suggest, says Morningstar analyst Kathryn Young. Young reports that the fund typically favors revenue bonds, which are repaid with revenues from a specified project, with a particular bent toward bonds issued by airports. The fund currently holds slightly higher weightings in health and transportation bonds than the category average. The fund beat its muni-national short competitors by at least 1 percentage point in three of the past four years, aided in part by its below-average 0.50% expense ratio. 

 Northern Tax-Exempt (NOTEX)  
Assets: $1.2 billion
This muni-national long fund, run by an experienced management team, takes a play-it-safe approach that has helped it avoid some of the volatility its peers have experienced. Along with mostly avoiding health-care bonds, it has recently steered clear of local government bonds in favor of state-sponsored issues that are less reliant on property taxes. The fund's 33.7% allocation to AAA bonds is well above the category average of 8.9%, and its conservative profile helped limit losses to 1.8% in 2008, when its peers lost 9.5% on average. The fund's five- and 10-year records are both in the top 20% of its category. Fees were recently lowered to 0.45% for 2012, below-average for the municipal long no-load category.

 Wells Fargo Advantage Intermediate Tax/AMT-Free   
Assets: $1.6 billion
With two experienced and capable managers backed by a sizable research staff, this fund is able to venture into more midquality credits than many of its peers, as illustrated by its 14.7% allocation to BBB rated issues, which is slightly higher than the category average. Its appetite for risk can get the fund in trouble, as when it lost 5.8% in 2008, placing it in the bottom quintile for the muni-national intermediate category. However, its long-term record is a good one, with top-third performance in the trailing three-, five-, and 10-year time frames. Its 0.73% expense ratio is above-average for the municipal intermediate no-load category, though its institutional and A share classes charge fees that are below-average relative to their peers.

Portfolio data as of March 31.