High-yield munis on a roll, if you can stomach them

High-yield municipal bond funds are getting a lot of love these days, thanks to their blistering performance and relatively high tax-free yields. With a return of just over 10% through mid-August, high yield muni funds are neck-and-neck with emerging-markets bond funds as the top fixed-income performers of the year. The promise of a 4% to 5% tax-free return in today's nearly no-yield environment has led to a stampede into the funds. Investors deposited $6.8 billion in high-yield bond funds through the end of July, the most since the funds took in a record $8.2 billion in 2006, according to Lipper Inc. Their performance contradicts the recent headlines of municipal bankruptcies and the continued predictions of doom and gloom from noted analyst Meredith Whitney. There's a good reason for that, too: High yield munis are generally isolated from the struggles of counties and cities. “It's one of the ironic nuances you wouldn't really know on the surface,” said John Miller, portfolio manager of the $7.5 billion Nuveen High Yield Municipal Bond Fund Ticker:(NHMAX). “A lot of cities and counties are struggling financially and that puts pressure on the general obligation bonds, but the high-yield market is really different.” High-yield munis generally are used to finance specific projects, such as infrastructure, nursing homes or housing for the developmentally disabled. Coupons depend on the ability of those projects to generate enough revenue to make the bond payments. For example, if the project is an airplane terminal but consumers cut back on travel because of the economy, the issuer may have a hard time making the payments and the investment suffers. With the outlook for the economy still up in the air, any change in sentiment could spell big trouble for the high-yield muni space, something Todd Calamita knows all to well. Mr. Calamita, principal of Calamita Wealth Management, recalls looking at a client's portfolio in 2008 and seeing the high-yield muni fund it contained had dropped 40%, a bigger drop than the S&P 500 suffered that year. The average high-yield muni fund was down 25% in 2008, compared to a 3% drop for the Barclays Aggregate Bond Index. “You put someone in a bond fund because they're looking for income or they're conservative,” he said. “High-yield munis could be in one year and out the next. I don't have the stomach for that.”