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 year-to-date return just north of 10%, high-yield muni bond funds are neck and neck with emerging-markets-bond funds as the top fixed-income performers of the year. The performance and the promise of 4% to 5% of tax-free income in this no-yield environment has sparked a stampede into the funds. Investors deposited $6.8 billion in high-yield municipal bond funds through the end of last month, the most since the funds took in a record $8.2 billion in 2006, according to Lipper Inc. The rally and performance are in spite of the recent headlines of city bankruptcies and the continued predictions of doom and gloom from Meredith Whitney, chief executive of an eponymous financial advisory firm. There is a good reason for that, too — high-yield munis generally are isolated from the struggles of counties and cities. Unlike general-obligation bonds, high-yield munis are used to finance specific projects such as infrastructure, nursing homes or developmental housing. Coupons depend on the ability of those projects to generate enough revenue to make the bond payments. Bondholders are taking on the risk that the projects won't be able to make those 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 bond payments.

A DISTINCTION

“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,”said John Miller, portfolio manager of the $7.5 billion Nuveen High Yield Municipal Bond Fund (NHMAX). With the outlook for the economy still up in the air, any change in sentiment could spell big trouble for the high-yield-muni arena, something that Todd Calamita knows all to well. Mr. Calamita, principal of Calamita Wealth Management, recalls looking at a client's portfolio in 2008 and seeing that the high-yield muni bond fund had dropped 40%, which is a bigger drop than the S&P 500 suffered that year; the average high-yield muni bond fund was down 25% in 2008, compared with 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,” Mr. Calamita said. [email protected] Twitter: @jasonkephart