Clarifying the world of municipal bonds

Careful selection yields a stronger portfolio

November 25, 2001|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

A good municipal bond fund might be a worthy addition to your portfolio. But to many investors, munis are a mystery. Instead of valuations, you've got credit ratings. Instead of brand names like Coca-Cola or General Motors, you get sewer bonds from small towns. It's a different world, but it's not too tough if you focus on a few key points. Here's a quick rundown:

1. Stick to high quality. I've written previously about how attractive junk bonds are. However, I wouldn't go into low-quality munis - especially if those were the only muni funds I planned on holding. The reason is that low-quality munis are generally illiquid and the pricing can reflect the manager's best guess, rather than reality. In the right hands, high-yield munis are a decent investment, but it's easier to start off in a space with a lot fewer potholes.

2. Choose a fund with a low expense ratio. With municipal bond yields near their all-time lows, you're giving away the store if you buy a high-cost fund. The Lehman Brothers Muni Index is yielding about 4.08 percent. Subtract a 1 percent expense ratio and you've lost one-fourth of your return. There are 66 national intermediate funds with an expense ratio of 0.75 percent or lower. You ought to be able to find one at a price point that suits your needs.

3. Focus on returns - not yield. Even if income is your goal, remember that you want a healthy payout five years from now, too. Some fund managers know that investors buy on yield, so they'll pump up their yield while eroding your principal. Essentially, they're returning your money to you. A lower-yielding fund that protects you from capital erosion will actually pay you more than the high-yielding capital-eroding fund in a few years, because the capital-eroding fund will be paying a high yield on a smaller asset base.

4. Look for good relative performance. With interest rates falling sharply, some of the best returns belong to those with the longest duration. Long duration means lots of interest-rate risk, and when rates fall that's great - but they can take a bigger hit when rates rise. Thus, if you simply screened for any type of muni fund and ranked by returns, you'd come up with those that take on lots of rate risk. That might be OK if your holding period is also long, but it's worth looking at other options.

Thus, you should see how a fund performed against other funds of similar duration. A simple way to do this is using Morningstar Fund Selector to screen within a category, because our categories are broken into short- , intermediate-and long-duration funds.

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