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By Christine Benz | 08-25-2011 04:48 PM

Value in Long-Term Muni Funds

Mutual funds with the flexibility to take advantage of attractive yields in long-dated municipal bonds are a good pick for individual investors, says Morningstar's Miriam Sjoblom.

Christine Benz: Hi, I am Christine Benz for Morningstar.com. In a 60 Minutes episode that aired in late 2010, bank analyst Meredith Whitney warned of a coming spate of muni-bond defaults amounting to hundreds of billions of dollars.

Here to discuss the current state of the muni market is associate director of fund research, Miriam Sjoblom.

Miriam, thanks so much for being here.

Miriam Sjoblom: Thank you, Christine.

Benz: So has that doomsday scenario for municipal bonds borne itself out so far this year? What are you seeing in the muni market?

Sjoblom: It just hasn't so far. I think we're on track to some predictions I've seen. Say, by the end of the year, maybe we'll see a little more than $1 billion worth of defaults this year. That's a far cry from hundreds of billions of dollars, and we just haven't seen any new huge issuers come and say, "we are in danger of not being able to pay our debts." And actually, if you compare with previous years, the trend, the default rate has actually been coming down in 2011.

Benz: So that's kind of surprising there. Investors, I think, were battening down the hatches and really selling munis in late 2010, into early this year. How has performance been? Has it translated into fairly decent performance?

Sjoblom: Well, it's stayed rough through January, but since then, we've seen a pretty big recovery for municipal-bond funds. And in general, long-term funds sold off the most from November to January. So, they've kind of had the biggest bounce this year, gaining for the year to date around, anywhere between 5% and 9%, depending on the type of strategy. Intermediate funds have done well, gaining around 3%-8%. So, you've seen really strong returns despite all the warnings at the beginning of the year.

Benz: So, have investors been getting back into munis after dumping them late last year and early this year?

Sjoblom: It's interesting. That was one of the reasons cited for the poor performance in the municipal-bond market. It was just that huge amount of outflows late last year and earlier this year. Now, flows have stabilized somewhat, and we started to see inflows into short and intermediate muni funds. We've actually still seen outflows from long-term funds as a group. So, I'd say, flows have stabilized, but they haven't really picked up. So, despite the fact that perhaps these credit concerns were overblown, you haven't seen a lot of investors coming back into the market.

Benz: You wrote a really interesting piece, Miriam, in Morningstar FundInvestor, where you talked about what you think could be a potential opportunity in long-term municipal-bond funds for people who have a sufficiently long time horizon. I'd like to talk about your thesis there and why you think they could be attractive for certain individual investors?

Sjoblom: Sure. As I mentioned, long-term funds have remained unloved. And it used to be, the long-term would be kind of the flagship fund at a fund shop because muni investors wanted income, and that's generally where you got the most income. But there's been so much volatility in early 2008 and late 2008, and since then, it seems like investors have made this trade-off in which they would rather have less volatility and accept less income for that.

So you've seen actually that intermediate funds as a group, have overtaken long-term funds in size. So, as a result, you've seen that yields on intermediate munis have really come down significantly. Some managers are making an argument that there's just not a lot of value in that area. So, you really are making a trade-off. If you want that less volatility, there's absolutely good reason to not want a very volatile offering, but there might be some value in the long end of the yield curve.

Benz: And one of the reasons you keep mentioning the role of funds and inflows and outflows is that, in contrast with some other market sectors, mutual funds are actually very big players in the muni market, right?

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