Wed, 15 Feb 2012
Morningstar associate director of fund analysis Miriam Sjoblom explains what drove municipal bonds' great performance in 2011 and what issues may lie ahead for muni investors.
Christine Benz: Hi, I'm Christine Benz for Morningstar. Municipal bond funds have been on a tear. Here to discuss what's been fueling that rally as well as what issues could lie ahead for municipal bond fund investors is Miriam Sjoblom. She is associate director of fixed-income analysis at Morningstar. Miriam, thank you so much for being here.
Miriam Sjoblom: Thanks for having me, Christine.
Benz: So, Miriam, let's just start by taking a look back. 2011 was a terrific year for municipal-bond investors. It didn't start out great, but it went on to be very, very good. What were the main factors that drove that very good performance?
Sjoblom: It's incredible looking back at all the concerns at the beginning of the year and then what a great year munis had. I think there are a few factors. First off, the sell-off at the end of 2010 and beginning of 2011 was so severe that it attracted some crossover buyers from the taxable-bond market. Investors like Bill Gross at PIMCO Total Return were coming in and buying up munis because they represented good value. Eventually you saw the dire default predictions at the beginning of the year didn't materialize. Investors had been leaving muni mutual funds, but that started to change about midyear. They started coming into intermediate- and short-term funds and high-yield funds, and then later in the year, they also got interested in long-term funds to a lesser extent. So you saw a renewed demand from mutual fund investors and from crossover buyers. Another factor was that supply was just very low, below historic norms last year. There just weren't new bonds to buy. So that can sometimes have upward pressure, pushing yields up and prices down in the market, but that didn't happen.
Benz: So, all of those factors are really good convergence for municipal bonds and bond-fund investors. Going forward though, you're looking at a category where a lot of funds have had double-digit returns during the past year. Should investors check their expectations a little bit given the tremendous run and given the reversion of the mean that we often see no matter what category your asset class it is? What is your take on that question?
Sjoblom: Absolutely. Let's just take Vanguard Long-Term Tax-Exempt as a sort of bellwether-for-the-market type of fund. Last year, it gained 10.7%, and the total return comes from income and capital gains. When you break that return down, about 60% of it came from capital gains. So, that means 6.6 percentage points from price return, and only 4-plus percentage points from income.
Now, fast forward to the beginning of this year, and I just checked that the latest SEC yield on this fund is at 2.5%, which is the lowest it has ever been. So, you have to look and see where is the potential for further price appreciation for this fund going forward; the income level is also very low. On the other hand, what if yields rise off these very low levels? Then you can be looking at your income at a very low level, but also there's possible price appreciation in the year ahead.
Benz: Miriam, if the muni market is maybe fairly valued overall, I know you talk to a lot of fund managers, so are they saying that there are buying opportunities in any one particular part of the market? What kind of themes are you hearing?
Sjoblom: The themes that we have been hearing from managers are really similar to what we're been hearing in recent years since 2008 when the muni market went from being this AAA rated, ensured, safe, and interchangeable market into being more of a credit market where you cannot depend on the safety net of insurers and you really have to do the fundamental research on the bonds.
Managers are saying they're finding good value in A rated and BBB rated parts of the market where you get more yield than AAA rated bonds or the higher-quality bonds. But as far as what sectors look attractive to different managers, you're going to find some disagreement. Some like health care while some don't like health care so much. But really the important thing is to examine whether your fund run by a team that has experience doing research and if they have enough manpower to cover all the ground because it's much more of a credit-picking market these days.
Benz: Can you think of any examples where managers you like have shown that they are good at sifting through the credits and maybe avoiding some of the junkier ones?
Sjoblom: Yes. There is one really great example from last year. AMR, the parent company to American Airlines filed for bankruptcy on Nov. 29. AMR actually backed some municipal debt, and some high-yield muni funds do invest in airline credits while some don't. On the day of the filing high-yield muni funds dropped 1%. One fund, Pioneer High Yield Muni, dropped 3.6% on that day alone because it had sizeable exposure to unsecured AMR debt.
Our favorite funds in the category, T. Rowe Price Tax-Free High-Yield and Franklin High Yield Tax-Free Income, don't invest in airlines, so they didn't see those losses. So, you actually saw big differentiation in performance in the high-yield muni category this year, and AMR was sort of the key to that.
Benz: So you want that credit research team to do the on-the-ground bond-picking for you. One thing I want to follow up with you, Miriam, is the long-term part of the municipal market. Back in August when we reviewed what was going on in munis, you had mentioned that managers were saying that that was the one pocket of opportunity. I'm wondering did that play itself out, and did those bonds become maybe more fully valued? Or do managers still think maybe there is opportunity at the long end?
Sjoblom: I talked about the gap between very long maturity, 22-plus-year maturity bonds and 10-year bonds, and that yield differential of about a 170 basis points is still the same. So in relative terms, I think managers still are finding some value by going out to longer maturities. However, that doesn't mean they're extending the overall interest-rate sensitivity, the duration of their portfolios. They might be positioning their funds to benefit from that big gap returning to something a bit more in the normal historical range. They could do that by offsetting the interest rate risk of very long bonds with very short bonds. But in general as far as asking whether this a good time to buy long-term muni funds, I think you just look at the Vanguard example that I walked through earlier.
Just looking at the flows from the past year, the Barclays Municipal Bond Index in January of 2011 was yielding about a percentage point more that it is today, and you had $12 billion outflows for January 2011. This year you are seeing yields at all-time lows, and we have more than $6 billion of inflows into the market. So you have to ask are investors timing this correctly? You look at the flows and prices where they are, and it's just not making sense. So I wouldn't say this is a good entry point for long-term muni funds.
Benz: So you have to check your expectations and don't expect overnight miracles. But if munis made sense for you couple of years ago, they might make sense now. You just don't want to pile a whole bunch of new money in at this juncture.
Sjoblom: Right. We don't know what yields are going to do from here; there are reasons they could stay low for the year ahead. That kind of just shows how difficult it is to time this. If you have a long-term muni allocation, now isn't necessarily the time to sell either. I would say stick to your allocation and try not to get your head spun around by the market's moves.
Benz: You don't want to get your head spun around by munis' very strong recent returns. Thank you so much as always, Miriam, for sharing your insights. We really appreciate it.
Sjoblom: Thank you, Christine.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.