Warren Pierson
Baird Intermediate Municipal Bond Fund
Age: 46
Credentials: BA, Lawrence University
Experience: Portfolio manager, Baird Intermediate Municipal Bond fund (2001-present); senior vice president, Robert W. Baird & Co. (2000- present); senior vice president and senior portfolio manager, Firstar Investment Research and Management Co. (1985-2000)
Ticker: BIMSX
Inception of fund: March 2001
Style: Municipal national intermediate
AUM: $182 million
Three- and five-year performance as of Dec. 5: 4.16% and 3.19%
Expense ratio: 0.55%
Front load: None
Minimum investment: $2,500
Alpha: 1.75 vs. Barcap Municipal

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Municipal bonds may have builttheir reputation with widows and orphans, but lately even daredevils are thinking twice. The deepening financial crisis is hitting states and municipalities on several fronts: declining tax receipts, less money from Washington and frozen credit markets. Add to that the credit downgrades that municipal bond insurers underwent early this year, and it's turning out to be a dark period for what was historically a safe asset class.

That suits Warren Pierson, co-manager of the Baird Intermediate Municipal Bond fund, just fine. In this environment an investor like Pierson, who gravitates toward high-grade bonds, can pick up some steals on AAA names. "There are great opportunities in this market," he says. "I just wish I could buy more of this stuff."

With just $182 million in assets, the fund is small. But it's one of the lucky few that had net inflows in 2008, which allows Pierson to be choosy in this buyer's market.

The inflows are the reward for standout performance in a year that punished asset classes across the board. Through Dec. 4, the Baird Intermediate Municipal Bond fund was up 3.5%, placing it in the top 1% of the national municipal category, according to Morningstar. Over the past three years, the fund is up 4.1%, beating 99% of its intermediate rivals.

Quality on Sale

Pierson and his boss, Mary Ellen Stanek, managing director and chief investment officer of Robert W. Baird & Co., the fund's advisor, believe that their conservative approach is cut for today's tough times. Muni bond investors are a conservative lot, and they aren't looking for a wild ride.

Only the highest credit quality names can deliver on that promise, Pierson and Stanek say. They focus on general obligation and essential service revenue bonds and steer clear of projects with narrow revenue streams, such as hospitals or amusement parks. "Typically, investors don't get paid to take risks in the muni market," Pierson explains. Plus, plain-vanilla general obligation bonds are easier to evaluate.

Today, finding top-flight munis cheap is easier than ever. "We call our strategy 'quality on sale,'" Stanek says. "Conditions in the marketplace are not business as usual." Consider the yield on the Bond Buyer 40, an index of 40 recently issued munis, now 6.32% compared with the 10-year Treasury yield of 2.65%. Generally, munis yield about 80% of what Treasuries do because of their tax-free nature. But that relationship has been turned around since investors have been fleeing to the relative safety of Treasuries. At the same time, munis have sold off.

In a weak economy, Pierson says, buying lower-grade bonds does not pay off. Ninety-three percent of the fund's assets are AAA-rated names. Avoiding risk also leads the Baird managers to focus on the intermediate part of the yield curve, which, they say, offers the best risk-reward tradeoff. Bonds maturing beyond 15 years do not offer enough added yield to compensate for their increased volatility, Pierson says.He estimates that the difference in yield for a five-year bond compared with a six-year muni is 20 basis points, yet the yield pickup between a 20—and 22-year bond is just three basis points.

Pre-Re Spree

One area the Baird muni team particularly likes is pre-refunded bonds, with roughly 80% of the fund invested in these types of issues. The bonds jive with the managers' high-grade, low-price strategy. Pre-refunded munis are created when a municipality takes on new debt to refinance old debt that was issued when interest rates were higher. Upon refinancing, the issuer uses the proceeds from the new deal to buy Treasury bonds, which are then placed in an escrow account. The income and principal of the original deal are secured by the Treasuries in the account. Pre-refunded munis are among the highest-quality munis because of this guarantee.

But retail investors often find them confusing. Because of their high quality they generally trade at a premium, which small investors also dislike. "We are buying these bonds at the same levels that other people are buying AA bonds," Pierson says. "We love them because of their known cash flow."