Many investors may be in the wrong municipal-bond funds.
Perhaps conditioned by outsized bond-market returns in the 1980s and early 1990s, investors have more than four times as much money in muni-bond funds with average maturities of more than 10 years as they do in funds with shorter maturities.It's true that longer-term bonds provide bigger yields. But, as the bond market has shown this year, long-term bonds are much more vulnerable to rises in interest rates than their shorter-term cousins.
"A lot of people don't understand how much additional risk they're taking for the added yield they're getting," says Maria Crawford Scott, editor of the American Association of Individual Investors Journal.
Let's take a look at two funds. EV Marathon National Municipal Fund, with an average maturity of 25 years, offers a plump 6.6 percent yield.
But as interest rates rose this year, the fund's total return yield minus the fall in the value of the fund's portfolio was a negative 4.2 percent for the first seven months.
By contrast, Vanguard Municipal Intermediate Term, with an average maturity of 7.4 years, yields a little less - 5.2 percent.
Yet this fund's total return was down only 0.8 percent in the same period.
In addition to being less risky, intermediate-term bonds have actually provided higher returns than long-term bonds.
Since 1926, five-year Treasury bonds have returned an average annualized 5.3 percent, while 20-year Treasury bonds have returned an average annualized 5 percent. Five-year bonds outpaced longer-term bonds in the 1950s, 1960s and 1970s.
"Income investors should concentrate on intermediate bonds and leave the 30-year bonds to the insurance companies, the institutional investors and the interest-rate speculators," says Jay West-more-land, a stockbroker for Legg Mason in Charlotte, N.C.
Which intermediate-term bond funds offer good value?
It's hard to beat Vanguard Municipal Intermediate Term (800-662-7447). The fund's microscopic 0.2 percent annual expense ratio is a major plus, since it's difficult for even the best fund managers to add much value in short and intermediate-term bond funds.
Managers Ian MacKinnon and Chris Ryon have done a fine job steering the fund through a variety of interest-rate climates.
For investors with fairly short time horizons of about one year to five years, Vanguard's Muni Limited Term is a good bet.
Also managed by MacKinnon and Ryon, the fund has an average maturity of only three years, yet still yields 4.2 percent.