After sizable outflows in March 2020, investors returned to municipal bond mutual funds, with consistent flows in the second half of the year, observes mutual fund analyst Todd Rosenbluth in CFRA Research's flagship newsletter, The Outlook.

Most municipal bond mutual funds are actively managed, which could prove important in 2021 given the current unique state and local budget challenges being incurred around the U.S.

Given the fiscal challenges state and local governments are operating under due to the loss of revenues caused by the pandemic, there is a likelihood that the Federal government will provide support — though it might not materialize nor prove sufficient.

However, experienced active managers have the ability to ascertain whether states and localities have the wherewithal to raise taxes, reduce expenses, or take other measures to improve their credit profile. Investors have strong choices when considering national municipal bond funds.

For example, Fidelity Tax Free Bond Fund (FTABX) is akin to a core bond fund with an average duration — a measure of interest rate sensitivity — of six years and more than 70% of assets invested in AA- and A-rated bonds. The fund’s largest stake exposure was to Illinois (18% of assets), but had meaningful positions in bonds issued in Florida, New York, and Texas.

The fund charges a relatively low 0.25% expense ratio, well below the 0.73% average. In addition, CFRA finds its risk profile and its reward potential to be above average.

For investors more concerned about rising interest rates, Goldman Sachs Short Duration Tax Free Fund (GDIRX) is a strong candidate. The fund’s average duration of 2.3 years will limit the downside risk when rates recover.

GDRIX recently had approximately 55% of assets in bonds rated AAA and AA, providing a higher quality tilt relative to peers. Geographically, New York (15% of assets), Texas (8%), California (8%), and Illinois (7%) had the highest representation. The fund boasts a modest 0.43% expense ratio.

CFRA’s five-star rating is driven primarily by the fund’s high reward potential. High yield means something different in the municipal bond world.

While taxable bond fund investors should expect most assets invested in speculative grade bonds rated BB or below, the high-yield municipal bonds typically have stronger credit quality than taxable bonds.

According to rating agency Moody’s, just 7% of high-yield municipal bonds defaulted in the 10-year period ended June 2020, far less than the 29% for global corporate bonds. In the first half of 2020, the number of issuers downgraded was in line with the number upgraded.

American Funds High-Income Municipal Bond Fund (AMHIX) had only a quarter of its assets in bonds rated BB or below, with 45% of assets investment grade and an additional 24% unrated.

Like FTABX, Illinois was the largest state represented in AMHIX (15% of assets), with 5% weights in bonds from Colorado, Ohio, Pennsylvania, and Texas.

The fund, which had a 0.68% expense ratio, had average duration of 7.4 years. While the fund’s risk profile is elevated, CFRA believes the fund has strong reward and outperformance potential.

Though there are lower-cost index-based options to consider, yield-hungry investors focused on tax-free income might prefer experienced and proven active managers determining what securities from what states to own.

The funds discussed above each earn CFRA five-star ratings; these ratings are given to funds we think have a high likelihood of outperformance in 2021.

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