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Values Abound in Munis

Historic opportunities have been available to municipal investors of late.

Lawrence Jones, 01/27/2009

We've been continually making the case for municipal-bond funds' attractiveness as an asset class since at least late-2007, so it makes sense for us to revisit that thesis now as we enter 2009. We were correct at the time, munis did look cheap, but what we didn't anticipate fully was that they would come to look much cheaper throughout the course of 2008.

As fallout from the subprime-mortgage meltdown and the liquidity crisis rained down on the economy, the municipal market suffered one dramatic jolt after another. The markets were depressed by a crisis of confidence in the creditworthiness of municipal-bond insurers, the failure of auction-rate securities markets, and significant sales of municipal bonds by highly leveraged market participants. Hedge funds that had taken advantage of municipal arbitrage strategies reportedly started unwinding them when losses on other positions, and margin calls, forced them to sell their most liquid positions. Moreover, in the first two thirds of 2008 the municipal market was on pace to produce a record year in terms of new issuance. But as hedge funds and Wall Street trading desks departed the market and retail mutual fund investors grew increasingly skittish, demand for the securities waned, putting great pressure on prices.

Thus, when we look at the yield spreads between high-quality municipal bonds and their comparable Treasury counterparts, we can see the essentially unprecedented situation brought on by these recent market dynamics. Yields on generic general-obligation municipal bonds have historically ranged between 80% to 95% of those of comparable maturity Treasury issues, as investors have typically accepted lower pretax yields on munis given their built-in tax advantages. Today, however, the yield on a typical AAA rated muni GO is near 4.72% while a 30-year Treasury is yielding 2.99%, or an astounding 158% yield ratio. Incredibly, in late 2008, during the financial crisis' most damaging period to date, this yield ratio topped 200%. By this metric, the estimated taxable equivalent yield for munis (at the 28% tax rate, assuming 5% state tax rate) would be 6.9%, and (at the 35% tax rate) would be 7.64%, according to Morningstar's Bond Calculator. The severe market disruptions suffered by virtually all fixed-income sectors in the months following the Sept. 15 collapse of Lehman Brothers, as well as the factors mentioned above, are largely to blame, although economic recession has raised fears over municipal budgetary health, too.

The increasing expectation of a deep and protracted recession raises the prospect of added municipal market stress, but the very nature of the sector is such that actual defaults are incredibly rare. A Moody's Investors Service study of average cumulative 10-year default rates for investment-grade munis from 1970 to 2005 placed the level at 0.07%, versus 2.23% for comparable corporate bonds. It's a different story in the mostly unrated high-yield segment of the muni market. Moody's study found that the average cumulative 10-year default rate for below investment-grade muni debt was 4.29%, many times higher than in the investment-grade part of the market. But while defaults are rare, credit-rating downgrades and issuer-specific troubles can cause bond markdowns that can injure investors' returns in the short run, sometimes greatly. This is a possibility that is particularly concerning in recession, as declining income, sales, and property tax receipts can cause significant budget shortfalls. And while some managers we speak with argue that the Federal government will support municipal balance sheets with its own, as it has many private-sector institutions of late, we still suggest that investors stick to higher-quality munis for now and avoid the below-investment-grade and nonrated sectors that can feel the most pain in a downturn.

Moreover, many of the muni managers we most respect suggest that there are excellent values to be found in this market environment. And while it is important to point out that the muni/Treasury yield ratio (illustrated above) may overstate the case for munis somewhat, considering that Treasury yields are at historic lows themselves, many argue that munis still look quite compelling when compared with other taxable-bond alternatives, such as agency-backed mortgage securities. Also, given the possibility of credit trouble ahead, we do think it's worth pointing out that it is better to invest in a diversified mutual fund supported by a deep research team, rather than purchase individual bonds, as the vast majority of individual investors do not have the ability to perform the due diligence required to judge bond-specific risk. Thus, here's a look at some of our favorite fund options in the muni world:

Fidelity Municipal Income FHIGX and Fidelity Intermediate Municipal Income FLTMX, which managers Christine Thompson and Mark Sommer run, respectively. Both of these managers have delivered a long record of success by sticking with a strategy of adding value through sector rotation, issue selection, and yield-curve positioning. Also, the managers have skillfully avoided some of the more problematic areas of the muni markets, such as tobacco bonds, aiding returns, and the group's deep research resources overall gives us great confidence in these funds.

Franklin Federal Tax-Free Income FKTIX is an excellent offering in the muni-national long-term category and is led by manager Sheila Amoroso, who uses a buy-and-hold approach, looking for bonds offering competitive yields and trading at reasonable prices.

And despite a recent manager change at Vanguard Long-Term Tax-Exempt VWLTX, the fund's incredible cost advantage continues to give the offering a leg up in the muni world, where costs matter to good long-term results as much as anywhere. Moreover, manager Reid Smith makes occasional credit and interest-rate shifts, but we have confidence in his experience and ability to navigate muni markets. With the built-in advantage that he has on cost, he can take fewer risks than rivals and still come out on top.

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