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By Christine Benz and Eric Jacobson | 12-05-2013 12:00 PM

Munis Still Worth a Look

With a tilt toward longer durations, worries over Puerto Rico, and large outflows, muni funds struggled in 2013, but they have something to offer investors, says Morningstar's Eric Jacobson.

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?

Jacobson: Exactly.

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.

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