Christine Benz: I'm Christine Benz for Morningstar.com. How do you know if municipal-bond funds belong in your toolkit, and what should you look for if they do? Joining me to address those questions is Miriam Sjoblom. She is associate director of fund analysis with Morningstar.
Miriam, thank you so much for being here.
Miriam Sjoblom: Good to be with you.
Benz: Miriam, I would like to start by talking about the tax case for municipal bonds. How do they work in terms of the tax savings?
Sjoblom: Well, the big advantage for municipal bonds is that if you own a municipal-bond fund in your taxable account, the interest income is not subject to federal income tax.
Benz: So, that's a big advantage, and there are also potentially state and local tax advantages as well.
Benz: Let's talk about how to do that calculation, about whether a municipal-bond fund or bond is indeed a better fit for you than a taxable bond or bond fund. How should investors think about that particular question?
Sjoblom: So, there is pretty simple calculation that an investor can do, and it involves creating the taxable equivalent yield from municipal a bond yield. So, you would take the yield of the muni investment that you are looking to invest in and divide it by 1 minus your tax rate. And that gives you what's called the taxable equivalent yield that you can then compare with a taxable investment to see does this makes sense for me to be in a tax-exempt option.
Benz: So, if after that calculation, the muni fund or bond is ahead of the taxable bond or fund, then you may be better off with muni?
Sjoblom: Right. And I should note, Morningstar.com has a calculator that can help you with that decision and comparison, as well.
Benz: One thing I know a lot of investors struggle with is if they are doing that comparison among a taxable-bond fund and a municipal-bond fund, how do they find apples-to-apples comparisons? So, what's an appropriate taxable fund to compare with a potential municipal fund that you're looking at?
Sjoblom: I think the view on this has changed in the past few years. Before the financial crisis, munis were seen as a AAA type investment. So, on the taxable side, a comparable bond might be a U.S. government bond or Treasury. Since then we've really discovered that the municipal-bond market has its unique dynamics. It's got unique supply and demand dynamics, unique credit dynamics that really make it tough to have a perfect comparison in the taxable market.Read Full Transcript
Benz: So, you shouldn't necessarily compare a muni fund to a taxable government fund, for example, if you are looking to make that comparison?
Sjoblom: That's right. A big example would be during the financial crisis in that fourth quarter after Lehman Monday [Lehman Brothers declared bankruptcy Monday, Sept. 15, 2008.] you saw munis sell off and Treasuries rally. So, there have been times where the two have diverged.
Benz: If I'm looking to find a good core muni fund if I've determined that municipal bonds might be a good fit for me--I know a lot of investors shop on yield, they look at the fund that is the highest-yielding and are attracted to that--how can investors get beyond looking simply at whether the fund has a good yield or not?
Sjoblom: Well, I think one of the also unique dynamics of the market is that it tends to have more interest-rate risk because a lot of municipalities issue much longer maturities, 20-, 30-year maturities. So, if you look at the highest-yielding fund, you might find that you are having more interest-rate risk than you would accept in, say, a taxable-core-bond fund.
So, I think, also, if you find out intermediate-term muni is sort of the kind of risk you want to accept, if you go for the highest-yielding fund, a lot of times that can be more of a warning signal than an actual selling point. It all depends on how much risk you are willing to take. And so I think looking at yield is good, but I think the way people use it as saying "I want the highest-yielding fund," it's actually good to gauge how much risk is this fund taking relative to its cohort.
Benz: So that high yield can in fact be a proxy for higher risk?
Benz: So, if I am looking at other attributes, what are the key things that you and Morningstar analysts would focus on when you are saying this is a good fund run by a strong management team? What kinds of things are you looking for?
Sjoblom: Well, first, I think it's important to see how long is your time horizon and how much volatility you want to accept. Beyond that, if you're looking into the core space, the intermediate muni space, I think going with a team that has a really solid research bench--we've seen a lot of headlines about muni credit troubles and by and large those have been isolated instances--but it's really the research team that can help your fund avoid you getting into trouble spots.
Benz: So, I now Fidelity's muni funds have long been among the favorites. Why do you recommend those funds so highly?
Sjoblom: Well, Fidelity is one of those firms that has a really great research foundation. This is true of other no-load shops like T. Rowe Price and Vanguard, Fidelity is pretty straight-laced. They are not going to use leverage or other tools to really pump up the yield of the fund. They are not going to also stretch for yield and take more credit risk when they don't think the market is paying them to do so. On the risk spectrum, they're a little more middle-of-the-road to conservative. So, Fidelity has also been consistently among the least volatile. Each of their funds tends to be among the least volatile in its peer group.
Benz: Another category where we've seen a lot of investor interest recently is in the high-yield muni space, and let's just do some stage-setting and talk about what those funds tend to do and also if there are any risk factors that investors should bear in mind when delving into that category.
Sjoblom: Those funds in the high-yield muni category invest usually half or more of their assets in bonds that are rated BBB and below, including nonrated issues. And nonrated bonds are sort of one-off issuers. They tend to just come to market rarely, they don't trade very often, and there is no coverage from rating agencies. They tend to have a bit more liquidity risk and potentially credit risk, as well. So, the big issue I think we've seen in the risk that you are taking in these funds is, in addition to possible default risk, a well-diversified portfolio, will minimize that still. But there tends to be a lot of volatility just from this liquidity component of when there are times when risk appetite wanes and investors are selling and because those bonds trade very rarely, those funds can sometimes experience steep price declines. That's what we saw during the financial crisis.
Benz: So, we've seen these funds rebound recently. Performance has been really quite good. Would you recommend that investors steer clear at this point given that the upside may not be that great?
Sjoblom: Well, I would say especially the funds that have done the best in that category and attracted lot of assets are the biggest risk takers. So, I think that it's a good idea to kind of steer clear or be cautious with those types of funds, but there are still good core holdings like T. Rowe Price Tax Free High Yield, which is a good one that doesn't take too much credit risk, doesn't use leverage. It's not going to be the highest-yielding fund in the category, but if you want to have on the margin some exposure to high-yield munis, I'd recommend that one.
Benz: Miriam, thank you so much for being here to provide an overview of what to look for in muni funds.
Sjoblom: Thank you, Christine.
Benz: Thanks for watching. I'm Christian Benz for Morningstar.com.