High-Yield Muni Funds That Dive Into Unrated Waters

As anyone who's ever participated in a holiday grab bag can tell you, it's awfully hard to judge the value of something just by looking at how it's wrapped. In the world of bond-fund investing, individual investors usually have a good sense not only of what kinds of bonds a fund invests in but--just as importantly--the quality of those holdings. Ratings agencies such as Standard & Poor's and  Moody's (MCO) rate bonds based on the credit quality of the issuer, and bond-fund managers might consider those ratings in assembling their portfolios.

But not all bonds are rated, and in fact those unrated bonds can add to a bond fund's risk profile. A recent study by the Federal Reserve Bank of New York found that the number of municipal defaults from 1970-2011 was actually much higher than previously thought, when unrated bonds are included in the count. Morningstar's Eric Jacobson recently discussed the dangers of investing in unrated bonds in this video.

Jacobson says some bonds aren't rated because the monetary value of the bond issue might be too low to warrant paying an agency to analyze the deal. Also, issuers may forgo having a bond rated if they expect it will receive low marks. This extra layer of uncertainty involved in investing in unrated bonds can result in higher yields as a reward for investors taking on this added risk, and many funds that invest substantial portions of their portfolios in unrated bonds fall in the municipal high-yield category. But Jacobson points out that investing in unrated bonds requires extensive research in the absence of rating agency involvement. Furthermore, he says investors considering funds with large stakes in unrated bonds should proceed with caution and consider such funds aggressive kickers to portfolios anchored in higher-quality munis.

Using Morningstar's Premium Fund Screener tool, we set out to identify high-yield municipal-bond funds with at least 25% of their portfolios in unrated bonds. To eliminate multiple share classes of the same fund we applied the distinct portfolio screen. In addition, we screened out institutional funds to concentrate on those available to all individual investors. Premium members can click here to see the full list. Below are profiles of some of the funds that passed the screen.

Invesco Van Kampen High Yield Muni (ACTHX)       
Percentage Nonrated: 53.1     
With more than half its portfolio in unrated bonds, this load fund obviously isn't afraid to walk on the wild side, for better or worse. The fund lost 24% in 2008 as the financial crisis worsened, but despite its unusually high stake in unrated fare, it still outperformed the Barclays Capital Municipal High Yield Index by 3 points. Jacobson points out, however, that unrated bonds can be difficult to trade in times of trouble, making this fund's large allocation a potential weak spot. The fund, which tends to stick with long-maturity bonds (average: 21 years), has produced top one third or better annualized returns in the high-yield muni category during the trailing three-, five-, and 10-year periods. The fund has a history of closing and reopening to new investors and recently closed again.

Oppenheimer Rochester National Muni (ORNAX)
Percentage Nonrated: 42.5
A portfolio heavy on unrated issues and its manager's use of leverage to stoke yield make for one of the most volatile funds in the high-yield muni category. As proof, consider that the fund recorded top fifth percentile returns in its category each year from 2003-06 before dropping to the bottom fifth amid the financial collapse of 2007 and 2008. A top first percentile performance during the rebound of 2009 was then followed by a bottom decile performance the following year. This herky-jerky pattern averages out to a top 15th percentile three-year annualized record but bottom 10th percentile returns for the trailing five- and 10-year periods for this load fund.

Lord Abbett High Yield Municipal Bond (HYMAX)
Percentage Nonrated: 31.2
In an effort to produce the highest yields, this load fund holds nearly two thirds of its portfolio in unrated issues and those rated BB or lower. It lost nearly 33% in 2008 but rebounded with a nearly 36% gain in 2009. Its long-term record has been subpar, with three- and five-year annualized returns in the bottom fifth of its category. The fund's manager sometimes uses leverage to boost returns.

Portfolio, maturity, and duration data as of June 30; performance data as of Sept. 24.