Muni-Bond Funds: Tax-free Duo

10/14/2014 9:00 am EST

Focus: FUNDS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Over the last year, investors have pulled $24.8 billion out of municipal-bond funds, largely thanks to scary headlines. But data shows that the default rate among the bonds in the S&P Municipal Bond Index was just 0.107% over the past year, notes Benjamin Shepherd in Personal Finance.

Nevertheless, you still have to pay close attention to what you’re buying, of course, which is what James Murphy does at T. Rowe Price Tax-Free High Yield (PRFHX).

With the average credit rating of the fund’s holdings at a mere BB, most people would expect it to be quite volatile.

That isn’t the case, since the fund’s three-year beta—a measure of volatility against a standard index—at just 1.02—is but a tiny bit higher than the 1.0 of the overall muni bond market.

With an average duration of 5.6 years (which means you can expect the value of the fund’s portfolio and share price to decline by about 5.6% for each 1% increase in interest rates), you can expect the fund to take a price-per-share hit when interest rates inevitably rise.

That said, if you’re a long-term buy-and-hold investor, you’ll be more than compensated over the long haul by the income the fund generates. While the fund is currently yielding 4.2%, you generally don’t pay taxes on the income municipal bonds pay. 

So, if you’re a middle-income investor who falls into the 25% tax bracket, that’s a taxable equivalent yield of 5.7%. Offering an attractive yield, that’s tough to match, T. Rowe Price Tax-Free High Yield is a buy.

For those who would like to own municipal bonds but prefer less risk, Fidelity Intermediate Municipal Income (FLTMX) is another good option.

While its listed yield is lower than the Price fund’s, at 2.8% (a taxable equivalent yield of 3.8%), its duration is also slightly lower, at 4.9 years, with an average credit rating of A.

Like the Price fund, the Fidelity fund’s managers pay close attention to the creditworthiness of bond issues, occasionally betting on out-of-favor names if their analysis shows a bond is more likely than not to be paid off.

The fund has returned 5.3% so far this year, underperforming the Barclays index by 1.8% though still in line with its peers.

That said, the fund is much less volatile than its benchmark, with a beta of 0.73, and is 11% less volatile than other intermediate-term municipal funds.

While the fund isn’t likely to set the world ablaze in terms of share price appreciation, its steady yield and low volatility make it ideal for risk-averse investors.

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