These Mutual Funds May Keep Rallying

Can municipal funds keep climbing? Yes. Fears of defaults, which plagued markets last year, should wane because of new support from Washington and changes in the market for municipal insurance.

For starters, the Obama administration's recovery plans should strengthen bond issuers. Before Obama was elected, municipal bond prices had been dropping partly because investors feared that the deepening recession could lead to defaults by states and cities. Then in late November, Obama began promising to pour money into states. Soon municipal prices began rising. The rally continued this year after the stimulus legislation provided $150 billion in direct aid for states. Recently, Rep. Barney Frank (D., Mass.) called for providing federal insurance for municipal bonds.

"There is growing support in Washington to make sure that the states stay afloat during the recession," says Andrew H. Friedman, a Washington attorney and consultant for Eaton Vance Investment Managers, a unit of fund manager Eaton Vance(EV Quote).

While assistance from Washington is pushing up bond prices, many issues remain at bargain levels. Yields on 10-year AAA-rated general obligation bonds, among the safest issues, are currently at 3.19%. That is the equivalent of a taxable bond yielding 4.43% for an investor in the 28% tax bracket. In comparison, 10-year Treasuries yield 3.17%.

Lower-rated municipals look like especially good values. To compensate investors for their additional risk, lower quality issues typically yield a bit more than the highest-rated bonds. From 1991 through late 2007, 10-year revenue bonds rated Baa, the lowest investment-grade rating awarded by Moody's, yielded about 70 basis points (0.70 percentage point) more than safe general obligation bonds carrying the top rating of Aaa. Then, with investors worried about defaults, the spread widened. It currently stands at 300 basis points, says George Strickland, a portfolio manager for Thornburg Investment Management.

Strickland says the shakier bonds are cheap because of unwarranted fears of defaults. "Municipal credit quality will hold up better than many people think," he says.

According to Standard & Poor's, the default rates of investment-grade municipals have been tiny. During an average 10-year period, only 0.13% of investment-grade municipals defaulted. With the economy in recession, the default rate could climb to 1%, Strickland concedes. But he says bonds are currently being priced to account for a 20% default rate. As long as defaults stay below that level, municipals will likely deliver healthy returns.

To take advantage of discounts on lower-quality bonds, Strickland recently opened Thornburg Strategic Municipal Income Fund(TSSAX Quote). The fund can buy bonds of all credit qualities, including those rated below investment grade. "This is a time when it pays to take some thoughtful risk," Strickland says.

Investors who have no stomach for risk should consider Thornburg Limited-Term Municipal(LTMFX Quote), which has an average credit quality of AA. Another cautious way to bet on a revival of the municipal market is Fidelity Intermediate Term Municipal(FLTMX Quote), which has an average credit quality of A.

Besides worrying about the weakening financial condition of municipalities, investors have been troubled by concerns about municipal bond insurance. When Ambac and other bond insurers faced problems last year, the value of insured bonds collapsed. That hurt returns of many funds. But now the threat of defaults by bond insurers has been neutralized.

Some funds have simply begun to avoid insured bonds. After losing 5.8% in 2008, Franklin Massachusetts Insured Tax Free Income(FMISX Quote) decided to take "insured" out of its name and drop the requirement that the fund had to invest 80% of its assets in insured bonds.

Vanguard Insured Long-Term Tax-Exempt(VILPX Quote), a fund with $3.2 billion in assets, was merged out of existence. "We concluded that a fund focused solely on insured bonds no longer provides tangible benefits," says Gus Sauter, Vanguard's chief investment officer, in a statement

Insurance has long been a mainstay of municipal markets. As recently as two years ago, half of all new issues were insured. Although few new issues are now insured, funds still hold plenty old bonds that are backed by insurance. Should you worry if your fund holds insured bonds? Not necessarily.

Prices of insured bonds have already collapsed to bargain levels. Portfolio managers say insured bonds aren't likely to fall much further. To appreciate why, consider how insurance works. Say that Standard & Poor's gave a hospital an A rating, a strong investment-grade mark. When it issued bonds two years ago, the hospital purchased insurance coverage. According to the insurance policy, the hospital would make regular interest payments on its bonds. The insurance would only come into play if the hospital defaulted. Because of the extra layer of protection, the hospital bond could be rated AAA. That improved rating pushed up the bond's price and made it easier to sell.

Then, in 2007 and 2008, bond insurers faced losses from mortgage-backed securities. With investors worried about defaults, prices of insured bonds dropped. The insured hospital bond fell back to trade according to its old A grade. In effect, the insurance had become worthless and had no impact on the value of the bond.

Now even if the insurers default, the bond market shouldn't be troubled. With the value of insurance already at zero, it cannot fall further.