'Superior value' in municipal funds

"Municipal-bond funds rated A or higher for credit quality and maturing in up to 10 years still offer exceptional value for investors in high tax brackets," says Philip Springer.

In Stephen Leeb's Income Performance Letter, the advisor offers an exceptional overview of the muni market as well as a trio of favorite funds.

"In general, this year's state budget deficits were closed through a combination of federal stimulus money, new borrowing, state reserve funds, spending cuts, tax hikes and one-time accounting gimmicks. 

"Yet big deficits loom for the current fiscal year and possibly for 2010-11 too. Closing those will be even harder.

"On one hand, holders of municipal bonds can take comfort that issuers generally will do what's necessary to meet their obligations. This helps explain why some investors see opportunity amid the turmoil that began in earnest last year.

"Yet the risk of investing in this increasingly troubled market has risen too. Some 48 states face fiscal stress, says the Center on Budget and Policy Priorities. In turn, states are slashing subsidies to municipalities, which are already struggling with reduced sales-tax and property-tax revenues.

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"Defaults on munis rose to record levels last year, but they're still relatively rare. Downgrades are common, though. The pace of credit-rating downgrades is accelerating, with S&P alone cutting credit ratings at more than double the pace of 2008.

"Despite these problems, municipals are very attractive now if you choose carefully. First, tax-free yields are still relatively high on a net basis compared with fully taxable bonds.

"For example, it's possible to lock in fully tax-free 5% yields in some cases. That's the equivalent of 7.7% if you're in the 35% federal tax bracket. Second, the tax exemption itself is likely to gain value amid the increasing probability of higher tax rates in the years ahead.

"For most investors, mutual funds are an easier option. They provide immediate liquidity and broad diversification, plus lower minimum investments.

"The biggest drawback: With bond funds, you cannot lock in a yield. Funds have no set maturity because their portfolios change with market conditions. Funds are also more expensive to hold over time too, given the annual management costs.

"Yet a well-managed fund offers advantages. Diversification and superior research are decided plusses during periods of economic stress. A fund manager can buy or sell based on changing credit situations and extend or shorten maturities based on their interest-rate outlooks.

"In fact, during economically difficult times, we prefer superior no-load mutual funds for their diversification, superior research, liquidity and low expenses.

"If you invest in municipals through just one fund, it should be a national fund that invests in many states because you need broader-than-usual diversification now.

"We recommend two no-load, low-cost funds that keep average maturity under seven years. Both rank in the top 20% of this category for performance over three, five and 10 years.

"Vanguard Intermediate-Term Tax Exempt (VWITX) is diversified both geographically and by type of bond. The key factor is quality: The portfolio overall carries an AA credit rating, with 95% rated A or higher. Current yield is 3.9%.

"Another favorite is Fidelity Intermediate Municipal Income (FLTMX). Its portfolio is slightly lower in quality, with 85% rated A or higher. But it also carries a modestly shorter average maturity.

"In addition, Nuveen Investment Quality Municipal (NYSE: NQM) is a long-term bond fund that also invests in many states. This is a closed-end fund that sells at a 7.7% discount to the value of its portfolio, makes monthly distributions and currently pays 5.5%t. 

"The fund uses 33% leverage, but a good chunk of the portfolio is in pre-refunded bonds that carry a U.S. guarantee. All told, some 70% of assets are in municipals rated AAA or AA.

"This fund's longer maturities plus leverage translate into more volatile performance. The Nuveen fund returned 26% for 2009 through mid-August following a 19% decline in 2008."