Despite the availability of lower cost ETF alternatives, municipal bond mutual funds gathered $81 billion of new money year-to-date through November 23, double the inflows for all of 2020, asserts analyst Todd Rosenbluth in CFRA Research's flagship newsletter The Outlook.

According to data from the Investment Company Institute (ICI), inflows were particularly strong during the third quarter, with these funds gathering $25 billion. While the Fed may begin raising rates in 2022, we still expect a low interest-rate environment, which makes higher-yield municipal bond funds remain appealing.

Year-to-date through December 3, the Bloomberg Municipal Yield Index, which owns high-yield and investment-grade rated municipal bonds, outperformed the investment-grade focused S&P National AMT-Free Municipal Bond Index by more than 300 basis points, because investors have been willing to embrace some risk taking.

Despite the name of the investment style, high-yield municipal bond funds tend to incur less perceived credit risk than corporate bond focused products. For example, American Funds High-Income Municipal Bond Fund (AMHIX) recently invested approximately 40% of its assets in bonds rated BBB or above, while taxable bond offering American Funds High-Income Trust (AHITX) owns just 3% in similarly rated bonds.

Investors benefit from the bottom-up research provided by active management, but what’s inside high-yield municipal bond mutual funds can differ.

For example, Franklin High Yield Tax-Free Income Fund (FHYQX) recently had 19% and 13% of assets in California and Florida bonds, respectively, while AMHIX only has 4.5% and 4.3% exposure to the respective states. In contrast, the managers for AMHIX saw greater value in bonds issued in Illinois (12% vs. 4.4% for FHYQX).

There are also some appealing yet less interest-rate sensitive choices for those seeking high-yield tax free income. For example, Nuveen Short Duration High Yield Municipal Bond Fund (NVHAX) had an average duration of 4.2 years, which is less than 6.5 and 7.1 years, respectively, for peers AMHIX and FHYQX.

However, just like with actively managed taxable bond and equity mutual funds, fees matter too. There are strong index-based ETF alternatives that charge net expense ratios of 0.35%, so investors using active mutual funds need to put what mutual funds they are considering into perspective.

AMHIX’s 0.65% is the cheapest of the trio of CFRA five-star rated funds highlighted in this piece, but the fees for FHYQX and NVHAX are only modestly above the municipal bond peer average of 0.72%.

Investors seeking tax-free income have some strong mutual fund choices. There are 220 CFRA five-star rated multi-state municipal bond funds as well as 125 state-specific alternatives. However, before deciding among them, it’s important to look at the holdings inside each portfolio and also consider fund expenses and past performance.

CFRA combines a fund’s relative performance record, fees, and risk-reward attributes to provide a forward-looking star rating. This unique approach is why our ratings on these mutual funds are higher than Morningstar’s, which bases ratings solely on past performance.

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