Dreyfus High Yield Municipal Bond fund has performed well in a hot sector of the bond market thanks to extensive research and a fresh start. By Thomas M. Anderson, Contributing Editor March 12, 2007 Does the slide of sub-prime mortgage market make you jittery about your bond investments? Consider municipal bonds, especially high-yielding tax-frees. High-yield munis led the way among bonds in 2006, returning 7% on average. They continue to rally as investor demand exceeds the limited supply of tax-free bonds issued.Investors who want professional guidance for high-yield munis have a relatively new choice. Dreyfus High Yield Municipal Bond (symbol DHMBX; 888-782-6620) gained 11% in its first full year of performance in 2006, which beat similar funds by 4 percentage points, according to fund researcher Morningstar. The fund, started in September 2005, is off to a strong start this year. It is a half a percentage point ahead of its rivals, with a 1.5% gain through March 9. The fund yields 4.6%, equivalent to a taxable 6.4% for investors in the 28% federal bracket. Research is what separates this fund from the crowd, says co-manager Michael Petty. The fund has five analysts who average 12 years of experience in studying the muni market, he says. When the managers contemplate investing in new issues, analysts visit the projects and talk with management. “They really beat the bushes,” Petty says. “We send them out all over the place.” Co-manager James Welch helps Petty scour the muni market for opportunities. Petty says the fund employs a “divide and conquer” strategy to analyze the high-yield muni market as much as possible. “Two sets of eyes and ears are better to shift through all the information,” Petty says. Advertisement Don’t confuse high-yield municipal IOUs with taxable junk bonds. High-yield municipal bonds are tax-exempt bonds that may be rated below BBB but often are just not rated at all because the issuing entity, such as a college dorm authority or a hospital system, doesn't borrow regularly and doesn't want to pay for a rating. The bonds aren't insured, but there's usually a sinking fund to give you some confidence that your principal and interest will be repaid if the issuer stumbles. Also, high-yield munis include specially issued bonds, such as state-backed debt issued against tobacco settlement revenues, which this fund holds. For now, Petty and Welch are investing in higher-quality bonds. They recently had about 40% of the fund’s assets in bonds rated BBB, which is one step above junk classification. Because of relatively narrow yield spreads, the duo see little reason to take the risks that lower-rated bonds typically entail. The fund has more than 30 holdings representing ten industry groups and 21 states. A good geographic mix of bonds is an admirable trait in a muni fund because it protects investors against risk if one region of the country falters. The managers tend to focus on tax-exempt bonds with longer maturities. The portfolio’s average duration -- a measure of interest-rate risk -- is seven years. That means that if interest rates rose one percentage point, the fund could expect to lose 7% of its value (or gain 7% if rates fell one percentage point). Many of the fund’s early positions were good bets. Petty and Welch bought bonds from the airline industry, toward which investor sentiment improved as fuel prices moderated and the industry consolidated. Bonds backed by the states’ settlement with U.S. tobacco companies also performed well as concerns over further litigation eased. Now, the managers say they are finding attractive deals among municipal bonds issued to finance hospitals and tax-exempt bonds backed by corporations. A fresh start has contributed to the fund’s outstanding performance. Newly minted funds often break out early in their existence, a phenomenon known as the new-fund effect. New funds are usually small, which allows the manager to take big positions as a percentage of the portfolio. Moreover, managers of new funds don't have to deal with the baggage of old portfolios. They don't have emotional attachments to long-time holdings that may have performed well in the past but are a drag on future performance. Finally, managers of new funds may be driven to generate good returns in the first 12 months because strong initial performance often attracts assets. The new-fund effect is usually mentioned in the context of stock funds, but it can also apply to funds that invest in less widely traded bonds. Advertisement Even with the new-fund effect, the Dreyfus fund offers a solid choice in the high-yield muni category. Petty and Welch have decades of experience in municipal bond investing between them and are backed by a seasoned research team. The $129 million fund has a 1% expense ratio, which is below average for high-yield muni funds. Expenses should drop as assets increase.