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This Mutual Fund Pays 3% Tax-Free

Pimco High Yield Municipal Bond gets a boost by holding tobacco bonds and avoiding Puerto Rican debt.

With stocks down and investors scrambling for income, high-yield municipal bond funds are now the number-two mutual fund category over the past year (behind only bear market funds). The funds mainly own low-grade tax-free debt issued by states and municipalities. Because muni issuers rarely default, their bonds are less “junky” than their corporate counterparts, says David Hammer, comanager of Pimco High Yield Municipal Bond PYMDX.

Hammer and comanager Joe Deane take their cue from a committee that sets the big-picture strategy for all of Pimco’s funds. The pair then turn to a team of 17 analysts, who assign grades to each of the bonds they research. The fund’s recent results were boosted by a big-picture decision to avoid bonds from economically troubled Puerto Rico and the analyst-driven call to allocate a hefty slug of assets (15%, at last word) to tobacco bonds—debt backed by revenue from a 1998 pact between states and cigarette makers.

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Hammer and Deane have become more defensive in reaction to a market they think has become overvalued. They’ve boosted the average quality of the fund’s holdings to triple-B-minus, the lowest investment-grade rating. They’ve also added more-liquid, easier-to-trade IOUs to take advantage of the greater volatility they expect in the junk muni market. The fund sports a current yield of 3.0%, equivalent to 5.3% for a taxpayer in the highest federal income tax bracket.

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