Thu, 27 Feb 2014
Munis have somewhat recovered so far this year, but investors need to mind all of the rate, credit, and valuation risks inherent in muni bonds and funds.
Christine Benz: I'm Christine Benz for Morningstar.com.
It's Tax Relief Week on Morningstar.com. Joining me to provide an overview of the municipal bond market is Eric Jacobson, he's a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Hi, Christine, nice to talk to you.
Benz: Eric, munis had a lousy year in 2013, but they've rebounded really quite well so far in 2014. What's been driving the recovery, in your view?
Jacobson: I think probably a couple of things. One is that fears about rates have sort of stabilized for now, in terms of rising yields. That's been something of a factor in part because the growth and inflation numbers are still pretty benign.
In that environment, too, there are at the same time probably fewer credit concerns, not as much noise in the last couple of months about some of the credit scares that drove the market during the second half of 2013.
So you've actually seen not only regular municipal bonds perform pretty well over the last couple of months, but actually having the difference in yields between municipals and Treasuries contract at the longer end, which is good to see in the sense that it indicates the market feeling there is little more health there, and that pushes up returns. High-yield municipals did quite well, too.
Benz: That's what I wanted to ask you. So high-yield munis have done well in this little window so far in 2014. Any other categories that have exhibited particularly good performance in the muni space recently?
Jacobson: A few of the narrower categories in the sense of specialized. The long-term municipal bond category for California did really well. New Jersey. Some of the other smaller states that don't have their own categories, all these did better than 3% for the year-to-date, and that's a pretty short time period, just since the end of 2013. Not as well down at the short end, and things that are not as rate sensitive but that's to be expected.
Benz: Duration risk, credit quality risk, all getting rewarded so far in these very early days of 2014.
Have investors begun to get back into munis? We saw a big retreat from them last year. Are you seeing more interest?
Jacobson: It's a little mixed. It really depends on where you are looking. Interestingly enough, as we just mentioned, the short-term categories haven't performed particularly well, but if you look at the year-to-date flows at least through the end of January, the biggest gainer [has been] what we call the muni national short-term category, with a little more than $900 million in inflows. You also had strong flows into the intermediate national muni space, and as I think you mentioned, the high-yield muni category in particular. Each of those were pretty close to $700 million each, and the high-yield muni category is a relatively modest category by size.
Everything else was pretty anemic, at least during the first month of the year. A big handful of single-state fund categories, and especially some of the longer-term categories like muni national long, they all had negative flows for January, and the muni national long-term category saw outflows of about $1.3 billion on a net basis.
Benz: In contrast with other types of funds where they are not huge players in their markets, muni funds are actually very big players [in the muni market] and may be in a position to drive performance a little bit if they are seeing big outflows.
Jacobson: Absolutely. I don't know if you want to think about it as the tail wagging the dog or the other way around, but big flows with funds in the municipal space absolutely have an impact on performance of the overall muni market.
Benz: Eric, I know that in the past we've talked about some of the clouds that investors saw gathering over the muni market--the Detroit bankruptcy filing, the issues in Puerto Rico. I know you have said in the past that Detroit bonds are not a big presence in many mutual funds. Puerto Rican bonds, however, are a bigger component of a lot of muni funds. How should investors be looking at that particular issue at this point--the effect of the Puerto Rican bonds on their fund portfolios?
Jacobson: I would say pretty much the same advice that we've been giving for the last several months, which is just that you really need to dig into your portfolios and see what you own.
Our data--which is mostly [as-of] the end of November, [that is] the most recent portfolio data we have for a number of these funds because of what fund companies have disclosed so far based on the calendar--there were about 25 funds that had more than 10% in bonds hailing from Puerto Rico, and then the longer tail is pretty long--there are maybe a 100-plus funds with 5% or more overall, and it's definitely worth knowing if your funds are among them.
One thing I would certainly mention is that there are couple of firms that--by now most people hopefully know this--but they've been pretty stalwart and staunch defenders of Puerto Rico, if you will, including the Oppenheimer Rochester Fund complex, Franklin's funds--and in fact they have a fund, a Double Tax-Free fund, that's probably shrunk somewhat, but it holds more than 60% in Puerto Rico. And certainly if you are a Franklin muni fund investor or an Oppenheimer Rochester muni fund investor, you'd definitely want to understand at least what you own and at least hear out, I think, probably what your manager is having to say about this if you're thinking about sticking around.
Benz: When you think about the muni market today, what do you view as the big risk factors that investors should be attuned to at this point?
Jacobson: The nice thing is, even with some of this rally, valuations are still probably a little generous relative to what they otherwise would have been, thanks in part to the sell-off over the summer. And even though we've got some of this yield-tightening that I was talking about among longer maturities relative to Treasuries, there's still potentially some value there. That's not a broad market call, but just looking at the historical numbers.
I think one of the most important things for muni investors to try and get a handle on is what kind of volatility they can expect in their portfolios--if not being able to look through a crystal ball at the credit market necessarily--at least to try to understand what kind of interest rate risks they're carrying around. Especially when they're buying longer bonds, that tends to be where a lot of the issuance concentrates. And even though, as I said, we've had outflows in January from the long-term muni portfolios, that in and of itself may trigger some people to want to get in. We also know, anecdotally, that people tend to look at muni funds more at the beginning of the year when tax season is upon us. So, you just really want to understand that if you're buying a long-term muni fund, in general, you're dealing with a bit more rate sensitivity than you would be with a core taxable fund because [the muni] market skews much longer.
Benz: One related question I have for you, Eric, is if investors are nervous about taking on that duration risk at this time, and maybe are concentrating their purchases in short- and intermediate-term munis, is there potential for that part of the market--which, as you say, isn't necessarily a huge part of the market--to get a little bit overvalued relative to the long-term bonds?
Jacobson: I definitely think that's the case. I don't have the numbers committed to memory in terms of how the shorter maturities did during the sell-off--I'm sure that they did a lot better than the longer-term pieces--but at the same time there have been two big things going on. One is the bigger reach for yield, and the other being this tendency to want to strip out interest rate/duration risk from your portfolios, and that has meant that a lot of people have essentially, as you implied, moved down the duration ladder, the maturity ladder.
It's tough to make a valuation call on the whole market, but knowing that that's the case, it's almost certainly not a place that you're going to get much extra bang for your buck. You're short to begin with, which means you're going to earn less than at the long end. And to the degree that people have already rolled down to the shorter stuff, it's pretty tight.
The one saving grace of that is, the shorter you get like that, the less volatility you're likely to have; sell-offs aren't as meaningful; rate spikes aren't as big a problem. But your ability to essentially extract much value out of the market based on what you're holding is pretty low.
Just by way of example, the three-year Municipal Bond Index, belonging to Barclays, had a yield of just over 0.7% as of yesterday. That's the kind of number that investors don't like to see to begin with, but it's important to look at it and recognize that that number has already been depressed some as people have flocked to that range.
Benz: You've hit on the importance of understanding your portfolio's credit quality exposures as well as the interest rate sensitivity that may or may not be embedded in the portfolio.
Are there any other tips that you would give people who are looking at munis at this time, maybe people who've just done their tax return or are working their way through them, and are determined to try to lower their tax bills? What should people have in mind as they're surveying the muni universe?
Jacobson: Apologies to our readers and viewers who have heard us say a lot of this stuff before--some of these things are just real critical to bring up. Obviously a Morningstar theme, we definitely want to keep expenses under control, especially in a low-rate environment in an area where yields tend to be low to begin with. If you're getting charged 90 basis points or 1% per year for the privilege of having a manager run your muni portfolio, you're potentially giving up a huge, huge percentage of your possible returns. Just by way of example, I was citing the yield on that shorter benchmark a minute ago, if you look at the yields on just the average municipal bond index, you're talking about, as of yesterday, it was 2.74%. A 1% expense ratio takes a huge chunk out of that income return that you might expect over the course of a year.
The other thing that I would strongly encourage people to do is at least think twice before you pile into individual bonds on your own, or have an advisor put them together for you. That's going to draw a lot of jeers, I know, from some of our readers who really love to do their individual bond investing. But what I would suggest is, apart from a lot of the other things that we argue with folks about, should you or shouldn't you buy a fund versus individual bonds, one thing that isn't often brought into the conversation too much is the fact that it's very hard to get really good pricing. Now, it's true that you can look at feeds and see what recent prices bonds have traded at in the marketplace from sources such as the MSRB, Municipal Securities Rulemaking Board, which certainly makes it a lot easier than it used to be, but if you're not trading in very large sizes, in particular, it's hard to get a good deal.
The other thing that I try to point out to people is, some of the things about those bonds that affect their prices are very, very hard for individuals to analyze and compensate for. I'm talking about things like the option risk embedded in call features that you have with municipal bonds, and some of the structures are even more complicated than that. They have sinking funds and serial issuance and so forth. How to know how much extra yield you should be compensated for essentially offering that option back to the borrower is a big deal. And the same thing is true, even more so now, for credit than it ever used to be, now that we really don't have much in insured issuance out there in marketplace like we used to when things were much more homogenous. Now, you've got very big differences across credit rating strata, and just knowing what's a fair price given the credit rating that you're dealing with can be a really big factor. If you go out there and just compare a bond to another bond and say, well this one has the same maturity and it's a similar issuer, that may not be enough if you don't know whether or not one bond or the other is really properly valued based on its credit risk.
Benz: Eric, thank you so much for being here to provide your insights on the muni market.
Jacobson: My pleasure, Christine. Good to talk to you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.