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By Christine Benz | 02-15-2012 10:00 AM

Muni Investors: Time to Check Your Expectations

Morningstar associate director of fund analysis Miriam Sjoblom explains what drove municipal bonds' great performance in 2011 and what issues may lie ahead for muni investors.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Municipal bond funds have been on a tear. Here to discuss what's been fueling that rally as well as what issues could lie ahead for municipal bond fund investors is Miriam Sjoblom. She is associate director of fixed-income analysis at Morningstar. Miriam, thank you so much for being here.

Miriam Sjoblom: Thanks for having me, Christine.

Benz: So, Miriam, let's just start by taking a look back. 2011 was a terrific year for municipal-bond investors. It didn't start out great, but it went on to be very, very good. What were the main factors that drove that very good performance?

Sjoblom: It's incredible looking back at all the concerns at the beginning of the year and then what a great year munis had. I think there are a few factors. First off, the sell-off at the end of 2010 and beginning of 2011 was so severe that it attracted some crossover buyers from the taxable-bond market. Investors like Bill Gross at PIMCO Total Return were coming in and buying up munis because they represented good value. Eventually you saw the dire default predictions at the beginning of the year didn't materialize. Investors had been leaving muni mutual funds, but that started to change about midyear. They started coming into intermediate- and short-term funds and high-yield funds, and then later in the year, they also got interested in long-term funds to a lesser extent. So you saw a renewed demand from mutual fund investors and from crossover buyers. Another factor was that supply was just very low, below historic norms last year. There just weren't new bonds to buy. So that can sometimes have upward pressure, pushing yields up and prices down in the market, but that didn't happen.

Benz: So, all of those factors are really good convergence for municipal bonds and bond-fund investors. Going forward though, you're looking at a category where a lot of funds have had double-digit returns during the past year. Should investors check their expectations a little bit given the tremendous run and given the reversion of the mean that we often see no matter what category your asset class it is? What is your take on that question?

Sjoblom: Absolutely. Let's just take Vanguard Long-Term Tax-Exempt as a sort of bellwether-for-the-market type of fund. Last year, it gained 10.7%, and the total return comes from income and capital gains. When you break that return down, about 60% of it came from capital gains. So, that means 6.6 percentage points from price return, and only 4-plus percentage points from income.

Now, fast forward to the beginning of this year, and I just checked that the latest SEC yield on this fund is at 2.5%, which is the lowest it has ever been. So, you have to look and see where is the potential for further price appreciation for this fund going forward; the income level is also very low. On the other hand, what if yields rise off these very low levels? Then you can be looking at your income at a very low level, but also there's possible price appreciation in the year ahead.

Benz: Miriam, if the muni market is maybe fairly valued overall, I know you talk to a lot of fund managers, so are they saying that there are buying opportunities in any one particular part of the market? What kind of themes are you hearing?

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