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By Christine Benz | 08-22-2013 03:00 PM

Don't Write Off Munis Out of Hand

Munis have faced both interest rate and credit risk pressures, but at current levels, this varied asset class is worth considering, especially for those in higher tax brackets, say Morningstar's Candice Lee and Eric Jacobson.

Christine Benz: Hi. I’m Christine Benz for Morningstar.com. Municipal bonds have been struggling so far this year, and investors have been fleeing the asset class. Joining me to provide some color on what’s been going on in munis are two of Morningstar’s municipal-bond experts. Eric Jacobson is a senior fund analyst, and Candice Lee is an associate credit analyst for Morningstar.

Thank you both for being here.

Candice Lee: Thank you.

Benz: Candice let’s start with you and do some stage setting. We’ve seen some very sharp price declines in municipal bonds recently. What’s been driving them down?

Lee: So far this year we’ve seen significant outflows out of muni mutual funds. The majority of those outflows actually occurred in June. In our opinion, the outflows in June actually are a reflection of the flight from credit risk and interest-rate risk for municipal-bond investors. June happened to be around the same time that the worries about the Fed tapering program started to take hold, so that certainly introduced an element of interest-rate risk to the market. Furthermore, mid-June was also when the Detroit emergency manager [Kevyn Orr] presented his debt-restructuring plan, which proposed an unprecedented treatment of general-obligation debt as unsecured. That certainly caused some reverberations in the market from a credit perspective, and so we think the confluence of those two events certainly contributed to those major outflows in June.

Benz: It was a perfect storm in a lot of ways.

Lee: Right.

Benz: How concerned should municipal-bond investors be about the Detroit bankruptcy filing? Do you think it will have a widespread reverberation throughout the muni market? What do you think are the implications for investors in, say, a broad-basket municipal-bond fund?

Lee: Certainly with all the headlines that Detroit is making currently, that understandably spurs some fears about the whole municipal asset class. But I would actually urge investors to caution against treating the entire muni asset class as being monolithic because I think the specific economic, demographic, and financial ailments that have been facing Detroit for decades are not really applicable to the market as a whole.

Broadly speaking, we’ve actually been seeing a lot of signs of improvement across the U.S. For states, we’ve actually seen both the number and the magnitude of state budget gaps decreasing significantly in recent years. The magnitude of the gap has been roughly halved between fiscal year 2012 and 2013. This is owing to stronger tax collections among states, and then also the gradually recovering housing market and labor markets have boded well for both states and local governments.

That being said, going forward, we are still concerned about some major issues that municipal governments have to say, particularly with regard to pensions and OPEB funding.

Benz: What is that?

Lee: OPEB meaning Other Post-Employment Benefits, such as health-care benefits for government workers. We’ve already seen the effects of pensions and OPEB on places like San Bernardino, Calif.; Chicago; Illinois; and of course, Detroit. Specifically with Detroit, we think that the results of the bankruptcy proceedings are actually going to have very far-reaching implications in the muni market as a whole, with regard to the prioritization of payment to creditors versus pensioners as well as the treatment of general-obligation debt going forward.

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