Christine Benz: I'm Christine Benz for Morningstar.com.
In a tough year for bonds overall, municipal bonds have dramatically underperformed. Joining me to discuss the category is Eric Jacobson. He is a senior fund analyst with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: It's great to see you. Thanks, Christine.
Benz: Eric, let's talk about municipal bonds and bond funds. We've seen pretty dramatic underperformance relative to taxable bonds. What have been the main drivers of these very poor returns?
Jacobson: I think there are a few things. One is that the municipal universe tends to tilt a little bit longer than the rest of the bond market given the way that funds tend to go on the taxable side.
Benz: So you have more interest rate sensitivity?
Benz: And that's not been helpful?
Jacobson: That has not been helpful.
The flipside of that coin is that a lot of people have been fleeing interest-rate sensitivity. There have been massive outflows from municipal funds, and that's certainly put selling pressure on what is typically a somewhat illiquid market.
Benz: Also the perception that some municipalities are not in great shape financially probably has weighed on the market. Let's talk about that issue. I was really struck by the fact that in the high-yield muni space, the performance is the worst of any muni fund category. In the taxable universe, high-yield funds have performed about the best.
Jacobson: Well, there are a few things going on. One is that Puerto Rico has affected some funds in the high-yield muni universe. You have the highest concentrations there, and Puerto Rico has performed quite poorly.
Benz: Let's talk about that specifically, because I think some people may be surprised to know that their municipal fund has Puerto Rican bonds at all.
Jacobson: What we've seen in terms of the muni-universe is that, a lot of single-state funds in particular that can benefit from the Puerto Rico triple-tax-exempt status have used Puerto Rico bonds to supplement their own local bonds in their portfolios. And sometimes, it's just because there is more issuance there; other times it's because there is a lot of yield to be taken there.
Benz: Yield is a little bit better on the Puerto Rican bonds. But we've seen them struggle. Why is that?
Jacobson: They've had some real fiscal issues in Puerto Rico. They run the gamut, and our municipal team has done a lot of work on that. But right now it looks like they are probably funded through the middle of 2014, but the headline risk was really bad over the summer. They took a real beating, because it sort of fed on itself and there was a perception that maybe they were getting in bigger trouble more quickly than people had expected. But by and large, a lot of the issuance that's actually in mutual funds at least is in the safer sectors within Puerto Rico.
Benz: The other big headline in municipal finances obviously is Detroit. How big a deal is Detroit for muni funds and how they have performed?
Jacobson: I would say arguably not as big a deal as Puerto Rico, in part because a lot of Puerto Rico's debt is actually related to pension obligations, rather than bonds, but even within the large segment of municipal bonds backed by names that involve Detroit, a lot of them are secured by certain assets and cash flows. A very large chunk are water and sewer bonds, a number of which are also servicing suburbs, and so forth. So a big portion of that universe has a reasonable chance of working out OK, at least in terms of bonds. And you can add to that the fact that of the largest municipal bond funds, you really are mostly talking about trace exposures of under 1% to Detroit earlier in the year. Most funds don't have very large exposures to the city other than a handful of Michigan-targeted funds.
Benz: It may not have been hard for fund managers to see that coming.
Benz: Eric, I would like to discuss the dynamic of fund flows as well, because in contrast with some other market segments, mutual funds are actually really big players in the muni market, and they've seen very big outflows so far this year.
Jacobson: That's right. And I think the story seems to be that that's had a really big impact. It's a double whammy, because you've got the interest rate sensitivity inherent in that longer kind of market, and you've got a comparatively illiquid market. A lot of municipal bonds don't trade that often. So when there is selling pressure, you can really feel it in the pricing. With investors doing the same thing in municipals that they have been doing in other places--redeeming, trying to get away from interest-rate risk--it's really had a depressive effect on pricing.
Benz: One thing we've seen in previous muni market cracks is that you actually start to get some taxable-bond fund managers looking at munis, even though it maybe is not within their mandates. Have you started to see that among fund managers you cover?
Jacobson: We've definitely talked to a handful that are considering adding some municipals or have already dipped their toes in a little bit. The tricky part for those big, taxable-fund managers is that same illiquidity issue. They don't want to buy something that they're not going to be able to sell that easily, or they don't want to build up large positions at least in bonds like that. And they also have some of the concerns about the volatility that the market has shown, and a lot of these same managers feel the pressure to be a little bit shorter in their portfolios because so many of their investors are anxious about rising interest rates.
Benz: If I'm looking at municipals or wondering if they should be part of my portfolio at all, what counsel would you give to investors at this point about how to think about munis given all they've been through and given some of the headwinds that you've just discussed?
Jacobson: I think a lot of it comes back to time horizon and whether or not you can handle some volatility from the market. They do have interest-rate sensitivity built into them, but the fact is that on a historical basis, they're certainly cheap to Treasuries, and that's going to provide you longer term a better income stream. So, if you're choosing among those kind of assets, you really, really want to consider municipals at this point.
But you might choose, if you're very, very nervous still about interest-rate risk, going with more of an intermediate fund. But over the longer-term, it's still an open question as to how soon rates may rise, so I don't necessarily advise people to be panicking about that.
Benz: I know you always say to run the numbers, use one of the bond calculators--we've got one on Morningstar.com--to compare what it looks like for you, once you factor in the tax benefits of owning the munis.
Jacobson: Exactly. People will often be surprised to find that there is a pretty strong advantage for buying municipal bonds even at what they might think of as middling tax brackets. It's definitely an exercise worth doing.
Benz: OK, Eric. Thank you so much for being here.
Jacobson: I'm happy to do it, Christine. Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.