Buy Pimco's Black Sheep

The bet is that a top shop's junk muni fund will recover quickly.

Pimco is widely regarded as one of the nation's best bond-fund managers. Led by Bill Gross, its funds have delivered outstanding long-term records. More recently, they dodged the subprime-mortgage mess. So what a surprise to find a Pimco bond fund near the bottom of its category.

Pimco High Yield Municipal Bond is the bungler. Over the past year to May 12, the fund's Class D shares (symbol PYMDX) lost 10%, placing them in the bottom 20% of funds that invest in low-grade tax-free bonds, according to Morningstar.

High-yield munis include those rated below BBB by Standard & Poor's or Baa by Moody's. More than half of the bonds in this category are unrated. The debt typically finances hospitals, transportation projects and schools. Manager John Cummings and his team prefer bonds serviced by revenue from public-works projects instead of those that rely on taxpayers of a municipality to repay the debt.

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Junk-rated munis took a licking during the past year's credit crisis, as investors sold practically everything that smacked of risk. But that's only part of the story. To guard against rising interest rates, Cummings sold short Treasury-bond futures, a bet on rising Treasury yields and falling prices. For most of the past year, however, Treasury yields tumbled, further denting performance.

Now here's the twist: The very factors that turned Pimco High Yield Muni into a dud over the past year could turn it into a winner in the coming year. The fund has stuck with its interest-rate hedge. And high-yield munis, like other risky parts of the bond market, have begun to recover as the credit crisis abates. In fact, from mid March through mid May, the Pimco fund returned 2.8%, beating the category average by a whisker.

Meanwhile, Pimco High Yield Muni yields a juicy 5.1%. That's equivalent to a taxable 7.8% for someone in the 35% federal bracket. The D shares, which are available through many discount brokers, levy no sales charge. The annual expense ratio is 0.79%.

Contributing Editor, Kiplinger's Personal Finance