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By Christine Benz and Eric Jacobson | 02-26-2014 03:00 PM

Tips for Investing in the Current Muni Market

Munis have somewhat recovered so far this year, but investors need to mind all of the rate, credit, and valuation risks inherent in muni bonds and funds.

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

It's Tax Relief Week on Morningstar.com. Joining me to provide an overview of the municipal bond market is Eric Jacobson, he's a senior fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine, nice to talk to you.

Benz: Eric, munis had a lousy year in 2013, but they've rebounded really quite well so far in 2014. What's been driving the recovery, in your view?

Jacobson: I think probably a couple of things. One is that fears about rates have sort of stabilized for now, in terms of rising yields. That's been something of a factor in part because the growth and inflation numbers are still pretty benign.

In that environment, too, there are at the same time probably fewer credit concerns, not as much noise in the last couple of months about some of the credit scares that drove the market during the second half of 2013.

So you've actually seen not only regular municipal bonds perform pretty well over the last couple of months, but actually having the difference in yields between municipals and Treasuries contract at the longer end, which is good to see in the sense that it indicates the market feeling there is little more health there, and that pushes up returns. High-yield municipals did quite well, too.

Benz: That's what I wanted to ask you. So high-yield munis have done well in this little window so far in 2014. Any other categories that have exhibited particularly good performance in the muni space recently?

Jacobson: A few of the narrower categories in the sense of specialized. The long-term municipal bond category for California did really well. New Jersey. Some of the other smaller states that don't have their own categories, all these did better than 3% for the year-to-date, and that's a pretty short time period, just since the end of 2013. Not as well down at the short end, and things that are not as rate sensitive but that's to be expected.

Benz: Duration risk, credit quality risk, all getting rewarded so far in these very early days of 2014.

Have investors begun to get back into munis? We saw a big retreat from them last year. Are you seeing more interest?

Jacobson: It's a little mixed. It really depends on where you are looking. Interestingly enough, as we just mentioned, the short-term categories haven't performed particularly well, but if you look at the year-to-date flows at least through the end of January, the biggest gainer [has been] what we call the muni national short-term category, with a little more than $900 million in inflows. You also had strong flows into the intermediate national muni space, and as I think you mentioned, the high-yield muni category in particular. Each of those were pretty close to $700 million each, and the high-yield muni category is a relatively modest category by size.

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