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If there’s one constant in the investment world, it’s that investors crave yield.
With the U.S. Federal Reserve now determined to keep interest rates at record lows in the hope of stimulating stronger economic growth, the hunger for yield has been harder to satisfy: the yield on the benchmark 10-year U.S. Treasury note dipped below 2.5% as recently as September 2010, and it hasn’t topped 5% since July 2007.
Normally, yield-hungry investors are not big buyers of municipal bonds. Muni bonds usually trade at an even lower yield than comparable Treasury bonds, because their interest payments are not subject to federal – and sometimes state – income taxes.
In recent weeks, though, concerns about a possible spike in defaults among muni issuers have pushed the yields on long-dated muni bonds above Treasuries.
In early January, 30-year muni bonds offered yields equal to 108% of similar Treasury bonds, according to a Bloomberg report.
Yet even yields that are attractive relative to Treasuries may not be enough to entice investors when Treasury yields are so low to begin with.
In that case, it may be time to investigate high-yield muni bonds, which comprise about 10% of the $2.7 trillion muni market.
These bonds are issued by less credit-worthy borrowers such as hospitals, nursing homes, schools and even private developers, so they must offer larger yields to attract buyers.
There are roughly 30 distinct mutual funds that invest in high-yield municipal bonds available to U.S. investors.
Over the past five years, performance among these funds has varied widely: average annual returns have ranged from a high of 3.62% to a loss of about 5%.
Most funds charge an upfront sales load, while annual expense ratios run from 0.55% to 1.84%. Almost all of these funds pay monthly dividends.
To identify the most attractive high-yield muni-bond funds, we screened for funds that are open to new investors, not intended for institutional shareholders and have a high rank from Standard & Poor’s methodology. We then chose three that have strong performance records and reasonable costs.
Among these funds, the Waddell and Reed Advisors Municipal High Income Fund stood out for its outstanding track record, reasonable fees and four-star rank from S&P.
The fund, which opened in 1986, owns the best 3-year, the second-best 5-year and the third-best 1-year performance record of all high-yield muni funds.
It does charge a 4.25% upfront load, but almost all of these funds do, and some charge 4.75%.
Its annual expense ratio is about average for the group. Its 274 holdings, though, put it on the lower end of the holdings spectrum for these funds -- a sign of potentially higher risk.
Its annual portfolio turnover of 16%, however, is low compared with its peers. Top holdings for the fund, which has about $650 million in assets, include bonds issued by the Mohave County Correctional Facility in California, the Harbor Point Infrastructure Improvement District in Stamford, Conn., and the Pennsylvania Turnpike Commission.
As of September 30, about 44% of its portfolio was unrated. It current distribution yield is about 5.4%.
Another attractive fund is the Delaware National High-Yield Municipal Bond Fund, which has about $210 million in assets.
This fund was the fourth-best performer over the past 5 years of all high-yield muni-bond funds, with an average annual return of 2.56% and the second-best performer over the past 3 years.
Its sales load (4.5%) and annual expense ratio are somewhat higher than those of the Waddell and Reed fund, but are still reasonable when compared to the group.
With just 174 holdings, though, it is less diversified than most of the other funds, and its annual turnover of 37% is relatively high for this type of fund. Its top holdings were bonds issued by the Texas Private Activity Bond Surface Transportation Corporation and the state of Minnesota, as well as bonds backed by Ohio’s tobacco-settlement payments. As of September 30, it had a yield of about 4.2%.
The Legg Mason Western Asset Municipal High Income Fund is also worth considering. This fund has the top 5-year performance record of all high-yield muni-bond funds open that long, placed in the top 10 for 3-year performance, and has one of the lower annual-expense ratios for the group.
The fund, with $850 million in assets, opened in 1992 and has about $900 million in assets. Its 198 different holdings make it a fairly concentrated fund for this group, and its 20% annual turnover is about average.
As of November 30, about 16% of its holdings were unrated. Its top three holdings were bonds issued the Brooklyn Arena Local Development Corporation in New York (that funds the construction of a sports arena), M-S-R Energy Authority (a public power authority in Modesto, Calif.), and the Texas Private Activity Bond Surface Transportation Corporation.