Despite low yields, municipal bond funds still make sense for conservative investors interested in principal protection, modest income and diversification against their equity portfolios.
Among our favorites are the national funds from T. Rowe Price, which have generated consistently strong tax-free income with superior risk-adjusted returns. All feature a long-tenured manager, an extensive corps of credit analysts, generally mild volatility, and a low expense ratio.
Longer-Term
T. Rowe Price Summit Municipal Income (PRINX) and T. Rowe Price Tax-Free Income (PRTAX) are both managed by Konstantine Mallas, who has run the former fund since 1999 and the latter since 2007.
In the 10-year period ended March 31, 2013, Summit Municipal Income produced an annualized total return of 5.4%, vs. 4.5% for its average peer. Over the past five years, Tax-Free Income has returned 6.2% on an annualized basis, vs. 5.8% for its average peer.
Mallas generally attempts to add return by emphasizing credit analysis rather than making interest rate bets in his funds. So, interest rate risk is moderate, while the funds can benefit from the selection of bonds that the research team believes to be undervalued.
Summit Municipal Income and Tax-Free Income have significant overweight positions in bonds rated A and BBB (about 45% and 14%, respectively, in each portfolio), the lowest two tiers of investment-grade ratings.
Mallas has limited the funds' allocations to the longest-term municipals (20 to 30 years until maturity) to about 40% of assets, vs. nearly 60% for the category. This should help limit damage from any rise in very long-term rates.
Both funds emphasize 'revenue bonds' over 'general obligation' (GO) bonds. As a generality, general obligation bonds are safer than revenue bonds. But with funds it makes less difference, thanks to the safety embedded in effective diversification.
Between the two funds, Tax-Free Income courts less risk, with a greater emphasis on investment-grade bonds and slightly less sensitivity to changes in interest rates. It also has a lower minimum initial investment ($2,500, vs. $25,000 for Summit Municipal Income).
Of course, because it has a milder risk profile, it also pays out less income. Recently, Tax-Free Income had an SEC yield of 2.2% (equivalent to a 3.1% yield for an investor in the 28% tax bracket), vs. 2.5% for Summit Municipal Income (3.4% tax-equivalent yield).
Shorter-Term
Charles Hill has managed T. Rowe Price Price Summit Municipal Intermediate (PRSMX) since 1994 and T. Rowe Price Tax-Free Short-Intermediate (PRFSX) since 1995.
Over the past five years, Summit Municipal Intermediate had a return of 5.5% on an annualized basis, vs. 5.1% for the average intermediate- term municipal bond fund—and with 15% less volatility to boot.
The Short-Intermediate Fund has consistently outperformed the short-term muni average; it has generated a five-year-annualized return of 3.6%, vs. 2.6% for its average peer.
Both funds share an emphasis on quality: virtually all of their holdings are investment-grade, and each has only about 10% of its portfolio in BBB-rated bonds.
To help generate at least some yield, Hill has reduced exposures to the highest rated AAA bonds and invested in bonds with longer maturities—but the funds' overall interest rate sensitivity remains mild.
In Summit Municipal Intermediate, he has added positions in tax-free bonds backed by corporate issuers, citing their generally strong credit and profitability. In both funds, Hill emphasizes revenue bonds in the transportation and healthcare sectors that Price's muni analysts have favored recently.
Summit Municipal Intermediate has a $25,000 minimum initial investment and a 0.50% expense ratio. Its recent SEC yield of 1.3% is equivalent to a 1.8% taxable yield for an investor in the 28% tax bracket.
Tax-Free Short-Intermediate has a $2,500 minimum initial investment and a 0.50% expense ratio. Its recent SEC yield was a tiny 0.4%, which rises to 0.6% on a tax-equivalent basis in the 28% tax bracket.
Higher-Yield
James Murphy has managed T. Rowe Price Tax-Free High Yield (PRFHX) since 2001. Over the past 10 years, the fund has generated a 5.7% annualized return, vs. 4.9% for its average peer—and, with about 11% less volatility.
High yield municipal bond funds tend to invest in both lower-rated investment-grade and below-investment-grade bonds. Murphy recently had roughly the same exposure to bonds rated below investment grade as his competitors' average (about 14% of the portfolio).
He has recently emphasized bonds rated 'A' and 'BBB,' which together account for about 60% of the portfolio. The fund is heavily invested in healthcare (about 30%), pollution control (25%) and transportation bonds (13%).
Tax-Free High Yield recently yielded 3.3%, equivalent to a 4.6% yield to a taxable investor in the 28% tax bracket. Its expense ratio of 0.68% is significantly lower than its average peer's 1.00%.
This is the riskiest of Price's municipal bond funds: Tax-Free High Yield lost 21.5% in 2008, vs. losses of 8.0% and 5.8% in Spectrum Municipal Income and Tax-Free Income, respectively.
Although Tax-Free High Yield has exhibited lower volatility than the high yield municipal average, it has been 60% more volatile over the past five years than Tax-Free Income.
However, investors who fear rising rates should be interested to know that during periods in the past when rates have gone up over several months, Tax-Free High Yield has tended to outperform most investment-grade municipal bond funds.
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