High-Yield Munis Are Due to Cool

High-yield municipal bond funds have had a terrific run in recent years. But with yields now at such low levels, investors should temper their expectations, says Jim Murphy, manager of T. Rowe Price Tax-Free High Yield (symbol PRFHX).

The average fund that invests in the debt of financially shaky state- and local-government entities returned 8.8% annualized over the past three years. (Over the past year, the average high-yield muni fund surged 11.0%. Interest payments from muni bonds are generally exempt from federal income taxes. Interest from bonds issued within an investor's home state may be exempt from state taxes as well.

Murphy's fund has done slightly better, returning 11.1% over the past year and 9.2% annualized over the past three years (all returns are through February 12). But after such a strong run, he's lowering his sights for the near term. "If we return 4% over the next year, we'll be very happy with that," Murphy says. That's because yields are so low, the best that even a brilliant manager may be able to do is clip coupons. Murphy's fund currently yields 3.2%. For an investor in the top federal tax bracket of 39.6%, that's equivalent to a yield of 5.3% from a taxable bond.

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Despite his fund's name, Murphy invests little in junk munis, or debt with below-investment-grade ratings. Recently 71% of the fund's assets were invested in bonds rated triple-B or better. "It is very difficult to run a pure-junk muni fund because, in general, munis are a very high-quality market," Murphy says.

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But he'll venture into low-rated bonds when he and his team of analysts think there's a strong chance for a turnaround. For example, he bought bonds issued by Barnabas Health in 2006, when its financial outlook was grim but before rating agencies trimmed its standing to double-B-plus in 2009. But Murphy added to his position in the West Orange, N.J., operator of health care facilities, both before and after the downgrades. Eventually, Barnabas's finances improved, and its investment-grade rating was restored. About 17% of the fund's assets are invested in hospital bonds, Murphy says.

More than 20% of the fund's assets are in muni bonds backed by corporations (companies may partner with municipalities to issue tax-free bonds if they use the proceeds to finance projects for the public good). For example, one of the fund's top holdings is debt issued by St. John the Baptist Parish, in Louisiana, and backed by Marathon Oil. The debt was used to fund the building of a new refinery during the rebuilding efforts following Hurricane Katrina.

Murphy says that large allocation to tax-exempt corporate debt is a boon for his fund, because it lets him leverage T. Rowe Price's corporate-bonds team to assist with analysis and research. For corporate-backed munis, the backing company has the obligation to repay the debt, meaning, for example, that the creditworthiness of Marathon Oil establishes the quality of the bonds Murphy purchased, rather than the creditworthiness of St. John the Baptist Parish.

The fund has a mandate to focus on long-term debt. The average maturity of bonds in the portfolio is 21 years, and its average duration, a measure of interest-rate sensitivity, is 5.8 years. That implies that the fund's price would decline about 5.8% in value if interest rates rose by one percentage point.