Five Compelling Muni-Bond Funds

Uh oh. Municipal bonds are the whipping boys again. Meredith Whitney is back on TV pronouncing doom, investors are redeeming muni funds, and the muni market is down 3%–10% this year depending on the category.

The reason for the sell-off and doomsaying is Detroit's bankruptcy filing. It's gotten a lot of attention, but at muni funds, the reaction has been more of a shrug. Muni managers saw this coming a long way off, and odds are that your muni fund doesn't have much exposure to Detroit. More muni issuers are under strain, but a slowly growing economy makes a wave of defaults unlikely.

The last time Whitney predicted doom, the market sold off, and fund investors redeemed their funds. Only, her prediction of $100 billion in defaults was off by roughly 50 times. When Armageddon didn't visit munis, the market rallied sharply.

With hindsight, that was a great buying opportunity. Is it possible that we're coming up on another one? So far the sell-off hasn't been as dramatic as the previous time, but muni yields are well above those of comparable Treasuries, whereas historically they've traded at lower yields because of their tax benefits. With that in mind, here are some ways to bet on a rebound.

 T. Rowe Price Tax-Free High Yield (PRFHX) has outlegged its peers by a decent margin since we made it a pick in 2005. We rate it Gold today because we like manager Jim Murphy's cautious stance in a high-risk space. T. Rowe has the analyst breadth to do thorough analysis on each of its holdings. That's crucial for a high-yield muni fund, as you really have to tread carefully. The fund is down 7.5% for the year to date, which is better than most of its peers. This fund is the most aggressive of those I've highlighted, but it does its job well. Many investors would be more comfortable with the funds below.

 Fidelity Municipal Income (FHIGX) has less credit risk than the T. Rowe fund, but it does have interest-rate risk, as you'd expect from any muni-national long fund. Low costs and skilled management have led this fund to outgun its peers since we made it a pick in 2002. Jamie Pagliocco is focused on downside protec­tion, as is apparent from the fund's top-quartile returns this year and in 2008. Fidelity aims to have better technology for modeling risks in a bond as well as an entire portfolio, and that's helped its muni funds perform well.

Silver-rated  Vanguard High-Yield Tax-Exempt (VWAHX) is so cautious on credit risk that it doesn't qualify for our muni high-yield category. So, its credit risk sits somewhere between the typical high-yield and national-intermediate category. With Vanguard's low costs, you still get a decent yield. The fund's 5.9% loss this year looks pedestrian compared with its intermediate peers, but that's still much better than 99% of the muni high-yield group. It's a good option if you want to trade a little risk for more yield, but only a little.

If you want to get really cautious, consider short or intermediate muni funds. These will take less interest-rate risk, though you lose some yield in exchange.

 Vanguard Limited-Term Tax-Exempt (VMLTX) is only a small step from a money market fund, but it's an important step. The fund has a high-quality port­folio with a 2.4-year duration. Its low 0.20% expense ratio ensures you get most of the small yield generated by the portfolio. However, that duration does mean the fund can lose a small amount. In fact, it is down 0.70% for the year to date. So, you get a little risk for that added return, but it's still useful for a lot of people.

 Vanguard Short-Term Tax-Exempt (VWSTX) is even closer to a money market with its 1.2-year duration. The fund is up 0.02% for the year as its more-modest interest-rate risk has protected it from losses. It's even short for a short-term muni fund, so it tends to lag in rallies. The fund's SEC yield is just 0.41%. You can use this as a place to invest money you expect to spend in a year or two or for your emergency-spending kitty.

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