December 20, 2004

Investors Stay Loyal to Municipal Junk Bond Funds

Dec. 16, 2004 -- Rising interest rates have spurred investors to abandon some bond mutual funds this year, but one group of fixed-income investments -- high-yield municipal bond funds -- has continued to attract money.

Funds that buy these securities have turned in good results so far, and that should continue in 2005, if interest rates move up gradually, money managers say.

High-yield municipal bond funds took in about $2.5 billion through October this year after netting approximately $2.8 billion in all of 2003, according to Financial Research Corp. Cash inflows into these funds increased each year between 2001 and 2003 after they suffered outflows in the previous two years.

Investors this year have pulled money out of funds that invest in other municipal bonds, notes Sam Campbell, an FRC analyst. Funds that invest in government bonds had also hemorrhaged cash through the first ten months of the year, FRC says.

Investors have been drawn to municipal junk bond funds by their relatively high yields, which have looked particularly good while interest rates remain low, money managers and others say.

"I think what you're seeing is that, in this low interest rate environment, investors have been seeking any additional yield they can find, and one of the ways to do that is to go down the credit spectrum," says David Kerwin, portfolio manager of the AXP High Yield Tax Exempt Fund/A (INHYX). That fund buys medium and high-quality municipal bonds and keeps a small portion of its assets in lower-rated municipal bonds to help boost yields.

The average high-yield municipal bond fund was up 4.6% this year through November, and 5.3% for the 12 months ending that month. By comparison, funds that invest in intermediate term U.S. government bonds gained 2.5% and 3.2% during those periods; funds that buy intermediate term investment-grade corporate bonds and U.S. Treasurys returned 3% and 4%.

Regardless of their performance over the short term, high-yield municipal bonds offer a number of benefits, observers say.

To start, unless an investor is subject to the alternative minimum tax, income on these bonds is tax-free, which can be especially beneficial for someone in a high tax bracket.

"People look at them for tax-exempt income; that's one of the primary" advantages of investing in the sector, says Jane McCart, who manages the Northern High Yield Municipal Fund (NHYMX).

Also, volatility and default rates on municipal junk bonds tends to be lower than with high-yield corporate bonds, observers say.

"Government entities are usually much more stable than companies," says Curt Fey, a financial planner in Pittsford, N.Y. "They don't usually default. But companies go under all the time."

McCart and John Miller, the manager of the Nuveen High Yield Municipal Bond Fund/A (NHMAX), notes that high-yield municipals, unlike corporate junk bonds, are largely unrated securities. Many issuers of municipal junk bonds are so small and borrow so infrequently that they don't want to pay for ratings, the fund managers say. McCart added that institutions, which buy a lot of municipal junk bonds, have personnel to analyze these securities, so they do not have to rely on ratings companies.

The Nuveen High Yield Municipal Bond Fund's class R shares turned in the best performance among high-yield national municipal bond funds for the 11 months and the five years ended in November. That version of the fund was up 9.8% and 9.3% (annualized), respectively, during those periods. Overall, funds in the category had an average annualized return of 5.2% for the five-year period.

High-yield municipal bonds are sold to finance things like airports, college dormitories, toll roads and water and sewage projects. They are backed by revenues on these projects.

Money managers say they are optimistic about prospects for high-yield municipal bonds and high-yield municipal bond funds next year. Even if interest rates do jump, high-yield municipal bonds will hold their value better than Treasurys, and if rates rise slowly yields on tax-exempt junk bonds will continue to look relatively attractive, they say.

"I think they'll perform quite well," Kerwin says.

Municipal Bond Funds

Best Performers 2004 Returns Through 11/30/04 (%) S&P Star Rank
Nuveen High Yield Municipal Bond Fund/R (NHMRX)

+9.8

5

Oppenheimer Rochester:National Muni/A (ORNAX)

+8.2

2

AIM High Income Municipal Fund/A (AHMAX)

+6.2

5

Delaware Group:National High Yield Muni Bd/A (CXHYX)

+6.0

4

J Hancock High Yield Municipal Bond Fund/A (JHTFX)

+5.9

4

Best Performers Five-Year Annualized Returns Through 11/30/04 (%) S&P Star Rank
Nuveen High Yield Municipal Bond Fund/R (NHMRX)

+9.3

5

Oppenheimer Rochester:National Muni/A (ORNAX)

+8.8

2

American Century High Yield Municipal/Inv (ABHYX)

+6.8

5

Scudder High Yield Tax Free Fund/S (SHYTX)

+6.5

3

Eaton Vance High Yield Municipals/A (ETHYX)

+6.2

4

Source: Standard & Poor's. Data as of 11/30/04.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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