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By Christine Benz | 11-08-2011 12:00 AM

Best Practices for Muni Investors

Morningstar's director of fixed-income research Eric Jacobson discusses who is a good candidate for munis today, the key criteria in analyzing a muni fund, and a few of his favorite fund names.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

We are focusing on fixed income all this week, and here to share some tips on what to look for in a municipal bond fund, as well as some best ideas, is Eric Jacobson, he is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: I'm glad to do it. Good to always talk to you.

Benz: So Eric, when people think about munis, first maybe they need to decide if they are a good candidate for municipal bonds. And I'm wondering if you can share some thoughts on how to make that decision? Are there any tools you would point people to?

Jacobson: Sure. The go-to way to do that is to take a look at what we call the taxable equivalent yield of a municipal investment, and there's a calculator in the Tools section at Morningstar.com that you can use. A lot of other websites and a lot of fund firms, I'm sure, have them as well. It's a pretty basic tool that helps do the math and figures out whether or not, given the tax brackets you are in and the kind of bonds you're looking at, does it make sense to purchase or look at a municipal bond or a municipal bond fund.

Now, it's sort of a little bit of an approximation, because you're using the yield as a proxy for whether or not it makes good sense. But it is a very useful way to look at it, and I think most people will be surprised to find that in today's environment, even the most modest investor--even at a 25% tax bracket for example, with say a 3% state income tax--can still benefit by buying a national municipal bond fund, if they're looking at a comparable investment that pays as much as 5%.

Once you start to get over 5% at those [tax] rates that I just cited, then you are looking at maybe the taxable investment working out better. But that's a pretty high number, especially given where Treasuries are today, and that's a fairly low tax bracket, relative to what a lot of folks who are in this area are looking at.

So once you're above that, into the higher [tax] brackets, it's almost a slam-dunk that munis are going to probably make sense for you. But I certainly would encourage people to go ahead and use the tool to check it out for themselves.

Benz: Okay. So if I'm looking at a given muni fund, how do I find a good comparison fund in the taxable space? What kinds of funds would I be looking for?

Jacobson: Well, that's certainly really hard, because for the most part they tend to be very high quality. You might just look at a regular core bond fund, something in the intermediate-term bond category for example. You might look at a government fund. But the thing you want to keep an eye on is what kind of interest rate sensitivity and what kind of credit quality you have.

For the most part, the long-term muni funds that you are looking at are probably going to have longer stated durations, and historically they might have had more volatility, but that's part and parcel of the fact that people have historically been willing to take on a little bit more interest rate sensitivity, given the higher yields that you get out there.

Benz: Okay. So if I've crunched the numbers and it does look like for me that municipals make sense, where should people start to obtain that good core municipal bond exposure? What category should they even look to?

Jacobson: Well, the first thing they want to do is figure out whether or not you need a single state fund or a broadly diversified, perhaps national fund. And I think depending on where you are, chances are you may already have a good feel for the answer. If you live in New York or California, it's almost certain that you probably want to go with a single-state fund. Although I will say people want to keep a close eye on those state finances. Nothing I've heard from any of the managers we've talked in the last couple of years suggest that they are really truly worried about either state running into actual default trouble. But you have to understand, especially for a state like California, all the machinations that go on in between now and the future. Regardless, even if they don't default, it could certainly cause volatility here and there.

But from a net result of how your returns work out, if you live in the state of California, as an example, a place that has a very high income tax rate, you probably are going to be better off with a single state fund. If, however, you live somewhere else in the United States, a state that either has a low tax bracket, or one like Illinois, a state that taxes its own municipal bonds anyway, you're probably better off with a diversified national fund, because you get that diversification and you give your manager a lot more options in terms of what he or she can buy in a portfolio.

Benz: Okay. So, once you've made that single state versus geographically diversified decision, ... what are the other criteria that you should focus on?

Jacobson: Well, some of the things I look for in a good core muni fund, for example--again you probably want to start looking in the Muni National Long-Term category. If you are willing to take some return potential off the table, you might look at the intermediate category. But for either of those, you want to look at things like transparency. And what I mean by that is, just looking at the materials that the fund company provides, do you feel like you're going to have enough idea every quarter, every half year when you read things, what really is inside this fund?

Nobody really wants to spend the time other than folks like ourselves to dig into the annual reports and look at the portfolios themselves. But at least just get a sense of, does this give me some comfort? Do I really know what's in there? Are there a lot of derivatives? Is there a lot of leverage in the portfolio?

A lot of times that stuff is in there, you can suss it out by looking at the schedule of investments, but maybe a fund manager or the marketing folks, if you will, don't mention anything about that in the letters that they write for the fund, or the graphs that they provide. That always bothers me. It doesn't necessarily mean they are trying to hide something, but it does mean you may not know what kind of risks are lurking underneath.

Overall, part two of that is, you just really do want to understand what are the drivers of return and volatility that make this fund tick. Can you figure those things out, either by getting some help from our research, or again just by looking at the materials that the fund company provides--especially if the fund you are looking at takes on any level of credit risk, which at this point is pretty much everyone: Does the credit research have a good record at this fund company? That's very difficult to suss out with municipals, just because there haven't been a lot of defaults. But you do want to try to get a feel for whether or not they are good at that kind of thing, because we are in a sort of up and down environment right now, where credit does make a difference.

Benz: So, I know that people often shop on yield and look at the yield, and maybe that's the beginning and end of their research. I'm guessing you think that that's not a great idea.

What is a better way to go about just getting your arms around the overall quality? You mentioned transparency is one thing. Any other things that you would point to as maybe statistics that people could latch on to as being especially meaningful in terms of making decisions about muni funds?

Jacobson: Some of the things that we do: We go back and look at what happened in 2008. What kind of practices did the fund have then? Are they the same now? A lot of funds used things called tender option bonds, which are essentially another way of saying inverse floating rate security, and it's a trust security which a lot of funds actually use to leverage up their portfolios.

You can tell in the portfolio whether it's leveraged by whether or not the total assets exceed the net assets. This is getting into a little bit of the weeds, and this is the kind of thing that we try to look at when we look at the fund. But you want to have a sense of how did the fund perform during a really rough period?

Another thing that we'll look at, in addition to 2008, is just the general level of the standard deviation of the fund, because you can tell if it's higher than the category average, is lower than the category average, as an example. These are the kind of things you can find on Morningstar.com. You want to just make sure you understand why that is. Is it because the fund has a historically longer duration than everyone else in the category, or is there something else going on?

Benz: I want to follow-up, Eric, on your assertion that a good starting point when looking for a core muni fund is the long-term category. I know when you talk about taxable-bond funds, you usually say the intermediate-term category is the place to start. Why long-term for munis?

Jacobson: Well, one of the reasons quite frankly is that's where a lot of the issuance is. A lot of municipalities tend to issue very, very long maturity bonds if they are able to in the marketplace, especially when pricing is good. So that's a case where it's very valid for investors to say, "Hey, just because that's what they are selling, doesn't mean I want to be buying." And if that's the case, you do want to ratchet down to the intermediate, muni national intermediate category.

But again, as I said earlier, a lot of times people have historically gone ahead and bought those longer-maturity bonds, because even though the municipalities consider the rates favorable, from an investor's perspective, those longer-term bonds do tend to offer the higher rates of return, higher income payouts.

As long as you don't wind up in a fund that really extends itself way out--and there aren't very many of those--you're probably going to be okay, because when I say long, I'm talking usually about seven, eight years in terms of duration, which seems pretty high and pretty long. But for the most part, it's a number that shifts around a little bit, and circumstances change. I wouldn't necessarily try to swear people off because that number sounds too high. But again you want to try to understand certainly how your fund looks compared to others, and perhaps an index as well.

Benz: In terms of favorite core fixed-income funds that are in the muni space, if I told you I were in the market for one, what are the top names that come to mind if you were going to make some recommendations?

Jacobson: Again, we are dealing with my personal favorites here to some degree, too, and I am always going to tell you that still today, Fidelity does a great job. They have a couple of terrific long-term funds, Fidelity Municipal Income, Fidelity [Tax-Free] Bond, the ticker on the second one is FTABX. Those are two of our favorites. We really love most of the funds that Fidelity runs. They have a very well-rounded shop there. We think they do a lot of great things.

Franklin and Vanguard both have very good muni funds, too, though. Franklin Federal Tax-Free and Vanguard Long-Term Tax-Exempt are both excellent choices, and any of those would probably be good options.

Benz: Now, I know that a lot of the higher-yielding muni funds have caught investors' eyes. First, what do you think of the category, generally, the high-yield muni category, particularly given the risks that potentially still overhang the muni market? And second, if you do think the category is okay, maybe for a portion of an investor's muni portfolio, do you have any favorites within that space?

Jacobson: Well, my main caveat would be this: We have not seen the chief risks of the high-yield muni category come to fruition for a long time, and that includes even to some degree in 2008 even though they did perform poorly overall.

But the chief risk that I'm talking about for the most part is liquidity--because a number of these funds hold very large stakes in non-rated bonds, and this is an ongoing argument that we have with fund managers, some of whom will tell us that the bonds they own are in fact very-very liquid, and that they always have a good bid if you will, there is always somebody wanting to buy them.

And while I can't necessarily tell you that they are wrong or that they are not telling the truth, it's a very, very difficult thing to have to rely on if you're putting a lot of your money in one of these portfolios, and for no other reason than the fact that if there is a scare of some kind, an unexpected scare, and people start pulling money out of one of these funds, that fund itself, no matter how liquid that portfolio may have looked at one time, that fund itself could face a run, if you will, and have a lot of people pouring money out and having the manager try to have to sell off some of the highest-quality assets.

In that case, even if he or she doesn't wind up selling the non-rated lower-quality stuff, it could wind up concentrating the fund and making it riskier. I'm not saying that people should absolutely stay away from these--most of them have been well enough run and have long enough records that they do look okay. But it's a concern that doesn't ever really go away, and it's one of the reasons we don't recommend a whole lot of them.

The other thing to watch out for is a number of funds in this category do load up on very sector-specific risks, including tobacco, airlines, and things like that, and the nature of the category itself is such that even things like health care, nursing homes, continuing care, retirement communities, are pretty well represented. On one hand, that helps provide some diversity--some of them tend to be less correlated to different factors like rising rates than others, but some of them, like I said, they tend to have their own volatility and risk profiles.

So we do like a few funds in there, and I can tell you about them, but it obviously becomes a big caveat.

Benz: So it sounds like in general you don't think that that high-yield muni component is a must have for most muni investors' portfolios?

Jacobson: That's right. I would favor ... if you didn't feel like you absolutely had to own one, I would probably stick to the taxable side for higher-yield area. But if you want to look at one, Franklin and T. Rowe Price, are two very well trusted firms that have funds that our analysts have liked for a long time. Franklin High Yield Tax-Free and T. Rowe Price Tax-Free High-Yield, and we're probably worried less about some of those factors in those funds than we do for a lot of others.

Benz: Eric, thank you for providing such a comprehensive overview of the muni space. We appreciate it.

Jacobson: Glad to help

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Funds mentioned in this video:

Fidelity Municipal Income FHIGX
Fidelity Tax-Free Bond FTABX
Franklin Federal Tax-Free Income FKTIX
Vanguard Long-Term Tax-Exempt VWLTX
Franklin High Yield Tax-Free FRHIX
T. Rowe Price Tax-Free High-Yield PRFHX

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