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By Miriam Sjoblom, CFA | 02-04-2011 02:05 AM

Today Is Good Entry Point for High-Yield Munis

Investors with a higher risk tolerance can obtain better-than-average rewards with high-yield munis, according to Franklin Templeton's Rafael Costas.

Miriam Sjoblom: Defaults so far have been mostly confined to the high-yield portion of the market, and you expect there could be more trouble there to come. Franklin has a high-yield muni fund. It's one of Morningstar's Analyst Picks, and we like the approach there. It's a bit different from others in the category. Can you talk a little bit about the opportunities and dangers in high yield and a bit about the approach in that fund?

Rafael Costas: Sure. Well, we manage all of our funds in the same office, with the same team and the same staff of portfolio managers and research analysts. Of course, in the high-yield fund you're going to pay even more attention to it from the research side. It happens to be a pretty high-quality high-yield fund. It's been. so for the last few years, something that helped us in the performance year of 2008, when the overall market was down.

Our fund held in pretty well, as you know, partly because it still had a lot of high-quality bonds in there, and frankly, it's still pretty high-quality. That's one thing that separates us. As you know, also at Franklin, we have never used leverage or that kind of strategy to pump up returns in the good years and caused so much pain in the down years. That also has helped both our relative volatility to that group of funds and also our performance over time, longer periods of time, which is what we like our investors to have, a long horizon.

We don't buy anything that we think is going to default in the fund. We rather not have to deal with defaults. The fact is that through the Great Recession, we had a couple of defaults in that fund. But, that's a pretty good record considering what we just went through as an economy. So, there are times like now, where the historical relationship in yields of our high-yield fund versus our investment-grade fund (Federal Tax-Free Income) widens out to a little more than the average and that's what we are now.

So now, it is actually a better time than average in terms of yield to consider buying this fund. And of course, high yield is not for everybody, but for the right investor who has a little higher risk profile, it's a good idea to see if you can pick up some extra yield now than you normally are able to pick up by just taking that incremental step and going from the federal tax-free fund to the high-yield fund. So, it is offering the high-yield market in general, a better-than-average reward now for taking the risk in our opinion.

Sjoblom: Just looking at the investment-grade funds in general, I think a lot of attention gets focused on a few issuers like California and Illinois, but there are really a lot of great issuers out there that are handling the situation pretty well and looking like a pretty good investment these days. What are some examples?

Costas: There are some 70,000 examples in the muni market. The muni market is unique in the sense that because we have these balanced budget requirements, some very hard decisions need to be made and they are made every year. So, you don't get to a problem like you're seeing, say, in the eurozone, where problems got postponed and now it's come home to roost and they're really in a tough spot, partly because of the way that we're structured that is very, very, very unlikely to happen in municipal finance.

So, we can find not only state bonds that essentially we don't think would default, but below the state level, there are things that essentially are like water and sewer debt, electric utility debt, and what we call essential services, that very often you rather own some of those than some general obligation debt or some smaller cities that are maybe unheard of.

People are scoffing that revenue bonds better than GOs, and you can't really answer that question categorically. There are some revenue bonds like I just mentioned that you rather own than some very small limited GO of small town with small flexibility. Yet also state GO bonds are very, very safe and we don't have any concerns that the state will default. So, it's all over the map.

But below state level there are significant issuers among large cities and small cities where you can count on the service that they provide being a service that people need, they need to pay for. For example, if you don't pay for your water, then you lose your water service, and you can't get it back until you make good on that bill. So, you have started thinking like that intuitively, and you see there a lot of municipal services are just that.

Municipal services that are essential (i.e. the people are willing to pay for that) wouldn't really default in tough times because they are also relatively inelastic, recession or not. You probably don't use that much more or less water or electricity at home, and again, you have to pay for it.

Now it's not that we don't have our riskier sectors, we have things like health care and housing projects that are a little more sensitive to recession issues. And for the individual investor in particular if they started looking at that kind of sector, then they might be taking a little more risk than they prepared to really accept when they find out some of the realities.

This is one of the beauties of municipal bond funds versus buying individual bonds, and it comes to light in periods like this that are difficult when people are getting nervous about what they read. The fact that you have a very experienced research staff whose job it is to identify, among all the things that you asked me, the best ones--the ones that we can feel fairly certain--will not have a big problem in terms of default. That is not saying it can't be downgraded or upgraded, but default is what we worry the most about.

That's where we add a lot of value, and we can go to our clients--if they've been in our investment-grade funds--and say through the Great Recession and beyond now, we haven't had a single default in any of the investment-grade funds. That is where a fund really can add a lot of value for the investor. Long answer.

Sjoblom: No, it's very helpful. Thank you very much for taking the time today, Rafael.

Costas: My Pleasure, and thanks again for having us here.

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