Riding the Muni Bond Revival
Northern Tax-Exempt fund benefits from its preference for high-quality debt.

After months of volatility, things are slowly returning to normal in the municipal-bond market. But they're not quite there yet. Muni prices rallied 10% from mid December through March 6, and the amount by which yields of medium-maturity munis exceed those of Treasuries narrowed from more than two percentage points to one. Still, that munis out-yield Treasuries at all is bizarre, given that muni interest is free of federal income tax and Treasury interest isn't.

Timothy McGregor, manager of Northern Tax-Exempt (symbol NOTEX), says there's good reason to think the worst is over. One major sign: Massive selling on the part of hedge funds appears to be finished. He also thinks that Americans' newfound penchant for saving will bolster demand for the bonds. So could President Obama's proposal to hike the top marginal tax rate to 39.6%, from 35%. Higher tax rates make the income from munis more valuable.

McGregor's fund has held up well because of its bias toward higher-quality bonds. At last report, 80% of its assets were stashed in bonds rated triple-A and double-A. McGregor says focusing on issuers' inherent creditworthiness, rather than on credit ratings, has also helped performance. Ratings agencies downgraded thousands of municipal bonds in 2008 after two of the largest muni insurers, Ambac and MBIA, were downgraded themselves. The Northern fund yields 3.7%, which is equivalent to a pretax yield of 5.7% for investors in the 35% tax bracket.