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 the best-managed high-yield muni offerings. (Morningstar categorizes high-yield muni-bond funds as those that invest a substantial portion of assets in high-income municipal securities that are not rated or that are rated at the level of BBB or below--considered high-yield within the municipal-bond industry--by a major ratings agency such as Standard & Poor’s or Moody’s.)

To streamline our findings, we focused on distinct portfolios of funds that earn Gold or Silver Morningstar Analyst Ratings. That screen winnowed down the list to a small number of funds, two of which we've profiled below. Premium Members can replicate this screen by clicking  here.

 Franklin High Yield Tax-Free Income (FRHIX)
Managing downside risk is a priority for comanagers John Wiley, Francisco Rivera, and Dan Workman. In addition to avoiding interest-rate bets, they also maintain a far higher-quality portfolio than most funds in the group. The fund's 60% stake in bonds rated A and above is almost twice as high as the category average, while the team holds roughly one fourth of the typical muni high-yield fund's position in nonrated bonds. (Nonrated bonds are often lower-quality.) Moreover, the team doesn't resort to leverage to bump up the fund's yield. Management'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 Gold fund's appeal. 

 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 500 issues. Although the portfolio's credit-quality breakdown doesn't stray far from the middle of the pack, Murphy makes minimal use of 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. 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 Nov. 17, 2011.