A Smooth Sailing Muni Fund

These are interesting times in the municipal bond market. The failing financial health of several muni-bond insurers has added volatility to the market. It's a rare event, but many munis, interest from which is free of federal tax, are actually yielding more than taxable Treasuries of the same term. That makes no sense.

Mark Sommer, skipper of Fidelity Intermediate Municipal Income (symbol FLTMX), has steered his portfolio through the turbulent muni market with skill. Over the past year through March 20, his fund, a member of the Kiplinger 25, returned 3.8%. That's 2.1 percentage points ahead of the Lehman Brothers Municipal Bond index.

Sommer traces the turbulence back to July 2007. The muni yield curve was flat (meaning that yields of short-term and long-term tax-free bonds were roughly equal) and the yield gap between low- and high-quality debt was tight. Suddenly, the credit crisis began descending on fixed-income markets. "Within a month, the world had changed," Sommer explains.

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This fund's performance held up because Sommer had concentrated the portfolio in high-quality muni bonds -- single A and higher -- and generally avoided lower-quality paper. Why? "High-yield munis had seen extraordinary sustained performance," he says. As investors poured in money, the spreads on high-yield munis narrowed to ridiculously low levels, much as they had in the taxable junk bond market.

All these stresses in the market are throwing up opportunities, and Sommer is positioning the fund accordingly. He's adjusting for a steepening yield curve and picking through insured bonds, many of which are selling at "irrational prices."

Many insured muni bonds, he says, are "penalized by investors who don't understand underlying credit quality." Some of these bonds are trading more cheaply than if the issuer had come to market uninsured. That, he says, makes no sense.

Sommer is well aware of the deteriorating state and local budgets in California, Michigan and elsewhere stemming from declining sales tax revenues and falling property prices. But he's nonetheless bullish on the muni market in general.

For one thing, higher income-tax rates, which are a distinct possibility, particularly if the Democrats win the White House, will make munis even more attractive to investors in higher brackets. "Munis are cheap now relative to Treasuries and other asset classes," Sommer says. "It's a good time to invest in munis."

This is a fine choice to serve as the core of your municipal-bond investments. It currently yields 3.4%, equivalent to a taxable 5.2% for a taxpayer in the 35% bracket. The fund's average duration, a measure of interest-rate sensitivity, is 5.4 years. That suggests that the fund's share price would fall about 5.4% if interest rates were to rise one percentage point.

The initial minimum investment requirement is $10,000. Annual expenses are a reasonable 0.42%.