15:41 10Jan07 -ANALYSIS-Time to take profits in high-yield muni funds

    By Dean Patterson

   WASHINGTON, Jan 10 (Reuters) - U.S. investors may want to

stop plowing record sums into high-yield tax-exempt bond funds

because the oversized returns of recent years are about to end,

leaving a lot of downside risk.

    Investors who are particularly concerned about capital

preservation may also want to take some of their cash out of

high-yield munis now to avoid potential price declines in the

future, money managers advised.

   High-yield munis have greatly enriched investors in recent

years and investors have responded by dumping large amounts of

cash into this very small part of the $2.3 trillion tax-exempt

bond market.

   But all or at least most good trades eventually end,

usually when least expected.

   High-yield muni funds took in a record $10 billion of new

cash in 2006, exceeding the prior record of $8.4 billion in

2005, according to flow tracker AMG Data Services.

   In fact, investors have pumped nearly $22 billion into

open-ended high-yield muni funds in the last three years and

the entire class of funds only totals about $58 billion,

according to AMG data.

   High-yield munis represent only about 4 percent of the muni

bond market, based on the weighting of Lehman Brothers' widely

followed indexes.

   "All this money chased a small amount of supply. That

explains why they did so well and why there is no downside

protection now," said Clark Stamper, manager of the Evergreen

Strategic Municipal Bond Fund in Corona Del Mar, California.

   The focus on high-yield munis has been nothing short of

intense lately.

   High-yield muni funds represent only about 16 percent of

the entire open-ended muni fund universe on a total assets

basis, according to AMG data. But high-yield funds accounted

for 61 percent of inflows over the last two years, and an even

higher proportion over the last four years.

   Institutional investors have been as eager to buy

high-yield munis as retail fund investors in recent years,

money managers said.

   "Right now no one cares about risk. It has been a good time

to reach for quality for more than a year," said Kenneth Woods,

chief executive officer of Atlanta-based Asset Preservation

Advisors Inc. "We have been trying to upgrade our portfolios as

much as we can."

   Overdone fund inflows is just one of several red flags that

have appeared in recent quarters pertaining to high-yield

munis, money managers said.

   Historically tight credit spreads between high-yield and

top-quality munis and low absolute yields are other key signals

that investors are not necessarily getting paid enough in extra

yield for the risk they are taking on with high-yield munis,

money managers said.

   High-yield munis have lower credit quality which generally

translates to bigger price declines when economic fundamentals

weaken significantly or investors suddenly decide to shed

credit risk en masse, money managers said.

   High-yield munis have had a good run due to improving

fundamentals, strong demand for yield, and being

under-appreciated in the past, investors said.

   High-yield munis as an asset class posted a total return of

more than 50 percent during the last four years, compared to

more than 19 percent for high-grade munis, according to

Lehman's indexes. All or most of that yield is exempt from

federal taxes.

   Bond fund managers usually can not match index performance

because their funds carry fees and they usually hold a portion

of their assets in cash.

   The average high-yield fund posted a total return of 29

percent over the last four years, exempt from federal taxes,

according to data from Lipper, a Reuters Company.

   The typical high-yield muni fund charges a 116 basis point

annual fee, according to Lipper. This gives fund investors even

less downside protection in a downturn because fund fees

usually do not go down when returns do.

   The typical high-yield muni fund yielded 4.39 percent at

the end of 2006, down from 4.71 percent at the end of 2005,

according to Lipper. Falling yield is another sign of less

downside protection.

   ((Reporting by Dean Patterson))