High-yield municipal bond funds have had a terrific run in
recent years. But with yields now at such low levels, investors
should temper their expectations, says Jim Murphy, manager of T.
Rowe Price Tax-Free High Yield (symbol
The average fund that invests in the debt of financially shaky
state- and local-government entities returned 8.8% annualized over
the past three years. (Over the past year, the average high-yield
muni fund surged 11.0%. Interest payments from muni bonds are
generally exempt from federal income taxes. Interest from bonds
issued within an investor's home state may be exempt from state
taxes as well.
Murphy's fund has done slightly better, returning 11.1% over the
past year and 9.2% annualized over the past three years (all
returns are through February 12). But after such a strong run, he's
lowering his sights for the near term. "If we return 4% over the
next year, we'll be very happy with that," Murphy says. That's
because yields are so low, the best that even a brilliant manager
may be able to do is clip coupons. Murphy's fund currently yields
3.2%. For an investor in the top federal tax bracket of 39.6%,
that's equivalent to a yield of 5.3% from a taxable bond.
Despite his fund's name, Murphy invests little in junk munis, or
debt with below-investment-grade ratings. Recently 71% of the
fund's assets were invested in bonds rated triple-B or better. "It
is very difficult to run a pure-junk muni fund because, in general,
munis are a very high-quality market," Murphy says.
But he'll venture into low-rated bonds when he and his team of
analysts think there's a strong chance for a turnaround. For
example, he bought bonds issued by Barnabas Health in 2006, when
its financial outlook was grim but before rating agencies trimmed
its standing to double-B-plus in 2009. But Murphy added to his
position in the West Orange, N.J., operator of health care
facilities, both before and after the downgrades. Eventually,
Barnabas's finances improved, and its investment-grade rating was
restored. About 17% of the fund's assets are invested in hospital
bonds, Murphy says.
More than 20% of the fund's assets are in muni bonds backed by
corporations (companies may partner with municipalities to issue
tax-free bonds if they use the proceeds to finance projects for the
public good). For example, one of the fund's top holdings is debt
issued by St. John the Baptist Parish, in Louisiana, and backed by
Marathon Oil. The debt was used to fund the building of a new
refinery during the rebuilding efforts following Hurricane
Murphy says that large allocation to tax-exempt corporate debt
is a boon for his fund, because it lets him leverage T. Rowe
Price's corporate-bonds team to assist with analysis and research.
For corporate-backed munis, the backing company has the obligation
to repay the debt, meaning, for example, that the creditworthiness
of Marathon Oil establishes the quality of the bonds Murphy
purchased, rather than the creditworthiness of St. John the Baptist
The fund has a mandate to focus on long-term debt. The average
maturity of bonds in the portfolio is 21 years, and its average
duration, a measure of interest-rate sensitivity, is 5.8 years.
That implies that the fund's price would decline about 5.8% in
value if interest rates rose by one percentage point.