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When hedge funds were dumping their best holdings to cover all the investment trash they couldn't sell, they tossed out a flood of municipal bonds.
Two weeks ago, "we were buying AAA-insured bonds at (a price to yield) 5.1%," marvels Hugh McGuirk, head of municipal investments for T. Rowe Price. When a tax-free bond yields more than Treasurys, "that's an extraordinary opportunity," he says.
Here's how that translates for investors: The T. Rowe Price Summit Municipal Income (PRINX) fund is yielding 4.07%.
For someone in the 28% federal tax bracket, that's equal to a yield of 5.65% on taxable bonds. The 10-year Treasury bond last week was yielding 4.75%.
Cash is no longer king. Bonds and money-market notes already have begun to trade at prices that anticipate a Federal Reserve rate cut of 0.5 to 0.75 percentage point. That will bring money-market yields to 4% or less. That, in turn, means low-risk municipals will be returning 40% more than no-risk money funds.
Once the domain strictly of the rich, muni bonds today provide better returns in taxable accounts for everyone. In the lowest tax bracket, 15%, a 4.07% tax-free yield is equal to 4.79%. The average long government-bond fund in the Morningstar database yields 4.28%.
And now is the time to embrace them. Their most important risk -- losing value when interest rates rise -- is an advantage when the pressure on rates is downward.
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Hocking their valuables
Right now they're on sale purely because hedge funds bought them on a massive scale to use as collateral for leveraged bets that went bad. Over the last six weeks, hedge-fund selling has depressed prices to the point that AAA-rated munis yielded as much as 98% the Treasury rate, up from the usual level of 85%. Currently their yield is 96% of the Treasury rate."What you've seen is just the ancillary effects of the general credit crisis, and looking at our market, it has made munis a wonderful investment," says Christopher Ryon, manager of Vanguard Long-Term Tax-Exempt (VWLTX).
Analyzing muni bond funds is complicated by the fact that, in addition to being exempt from federal income tax, states and localities also exempt their residents from local levies. So a state-only fund is better in high-tax states like California and New York.
But anyone can buy a national fund and at least escape the highest tax rate, which is federal. Three of the best mutual-fund complexes each offer an outstanding national fund. They are the T. Rowe and Vanguard funds, and Fidelity Tax-Free Bond (FTABX).
T. Rowe Price Summit Municipal Income: This fund has ranked among the top 10% of its rivals for the last three, five and 10 years, and for 15 years has delivered annualized total returns of 4.45%, as of Sept. 4.
Nearly half the fund's $445 million of assets are concentrated in AAA-rated bonds, and the overall portfolio quality is AA, the second-highest-quality tier. Holdings span the nation, from state of Hawaii bonds maturing in 2021 to a New York issue that matures in 2012.
The fund owns more than 350 bonds in total and holds them an average of five years; turnover is 19%. No single issue accounts for more than 2% of assets. Maturities are blended to produce an average of 14 years. The interest-rate risk is considerably less, however; it is 5.35 years, meaning that's how long it takes for the bond investors to earn their principal back, through a combination of interest, bond sales and refundings.
The Summit fund, which has a $25,000 minimum, generates a small sliver of its income from bonds that are subject to the alternative minimum tax, such as those issued by industrial development authorities. If you are subject to the AMT -- and the formula is so complex that even your accountant will wrestle with the answer -- you can avoid it through T. Rowe Price Tax-Free Income Fund (PRTAX). It yields 4.03%, eschews AMT bonds and has a minimum of $2,500.
Commenting on the Tax-Free Income fund, Morningstar analyst Scott Berry says: "This fund's returns don't tend to stray far from those of its peers. And when they do it's usually for the better. Veteran manager Mary Miller takes few chances."
A deep pool of talent
Fidelity Tax-Free Bond: Also avoiding AMT bonds, this fund has racked up top-15% returns since it was launched in 2001, with five-year returns of 4.31%. It also yields 4.03%. The minimum is $25,000, and the expense ratio is a minuscule 0.17%.Fidelity has an especially deep pool of talent and experience on its muni-bond team. It puts particular emphasis on bonds of the highest quality, not only in the financial security of their issuers but also with the strongest credit protection for bondholders. That has helped insulate it from collateral damage this year as panic over the subprime mortgage mess has spread to all credit-sensitive markets.
"There are two big reasons we're not worried that the success from such shorter-term victories will be fleeting," says Morningstar analyst Andrew Gunter. The research methodology that identified those winning bonds of 2007 is built into the fund's design.
And, "The team's close attention to each bond's call features and covenants should help this fund's relative returns (even) if the next few years aren't as favorable to muni investors as the last few were."
Vanguard Long-Term Tax Exempt: This fund sports some amazing features -- an expense ratio of just 0.16% and a current yield of 4.68%. If you're in the 28% bracket, that's equivalent to 6.5%. (You calculate taxable-equivalent yields like this: the tax-free rate divided by the tax rate subtracted from 1. Thus 4.68 is divided by 0.72.)
Add to that a minimum of only $3,000 and you have a very inviting portfolio. Morningstar lists it among its Analyst Picks, meaning that the fund-analysis company considers it among the top four funds of its type. Fidelity Tax-Free Bond is one of the other three.
The Vanguard fund's average credit quality is AAA. Its recent returns have lagged its top rivals -- five-year annualized returns of 3.77% -- largely because of the exceptionally high quality of its bonds. Vanguard has 69% of assets in AAA bonds, compared with 45% at T. Rowe Price Summit Municipal and 64% at Fidelity.
Ryon has proved adroit at assembling his portfolio of more than 250 individual issues: His average holding period is more than 12 years.
As recently as earlier this year, the Vanguard fund owned some AMT bonds, but Vanguard says they have been eliminated.
The municipal marketplace has hazards for investors. In addition to above-average interest-rate risk, many muni funds accept significant credit risk as they reach out for higher yields. The average long muni fund has an expense ratio of 1.07%, meaning its manager spends a fifth of investment income paying himself. Since investors would notice such a huge price tag, managers patch over it with higher-yielding -- i.e., riskier -- bonds.
This is an especially bad time for risk, however. These low-cost funds -- T .Rowe Price Tax-Free Income has the highest expense ratio at 0.52% -- avoid risk without sacrificing returns. If you are tempted to lock in today's yields with a bank certificate of deposit, you could do better in any one of these funds.
At the time of publication, Tim Middleton didn't own any securities mentioned in this article
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