Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. It's Tax Relief Week on Morningstar.com. Joining me to discuss some of Morningstar's favorite municipal-bond funds is senior analyst Beth Foos.
Beth, thank you so much for being here.
Beth Foos: Thanks for having me.
Benz: Before we get into some of the specific funds that you and the team like, I'd like to talk about the case for holding municipal bonds inside of a taxable account. What are the tax advantages of doing that?
Foos: Well, muni bonds are most attractive for folks who are looking to manage the tax consequences of their investments, primarily because the interest earned on muni bonds is generally free from federal income taxes. Depending on where that investor lives, muni bonds can also be free from state income taxes and local income taxes as well.
Benz: So, if I live in California and I'm buying California bonds, I'll get the national tax break and then I may also get the state and local tax break, too.
Benz: Let's get into the performance of munis before we get into the specific funds that you want to talk about. Performance has been really good.
Benz: When I look across, year to date, through mid-February or the one-year trailing returns, every single muni category is in the black. What has been driving that? That's better than is the case for the taxable-bond categories, where you have various categories that have sunk.
Foos: Absolutely. Munis actually fared relatively well through the rocky markets of 2015, and that has also remained true in 2016. I think it was actually one of the top-performing fixed-income asset classes for 2015 and is doing, again, as you said, very well in 2016. I think that's primarily because we've seen some of the larger issues that were weighing down the taxable-bond and equity issuers, such as the decline in oil prices or the general concern over slower economic growth primarily in emerging markets, just don't impact muni issuers as directly or as significantly or immediately as they do some of those other issuers.
We saw a lot of that market volatility in the corporate-bond and equity space cause some flight to quality for investors, especially in the second half of 2015. Munis have always been regarded as a higher-quality, lower-volatility sector. So, we saw a lot of inflows into muni funds; at the same time, issuance was kind of flat or lower than historical levels.Read Full Transcript
Benz: So, how does issuance help munis' performance--low issuance specifically?
Foos: When you see high demand and you don't see a lot of new issuance, obviously the bonds that are currently out there are going to have higher price points.
Benz: But it's interesting that even though municipal finances haven't been on the front burner--other things have been concerning the market--municipal finance troubles haven't gone away. We live in Chicago, Illinois, where certainly there are plenty of issues. Let's talk about that and talk about the state of municipal finances and how investors are thinking about that today.
Foos: I think we have seen--and will continue to see--some very stressed situations grab the headlines over 2015, and that's going to continue into 2016. As you mentioned, the City of Chicago has quite a significant budget struggle as well as the State of Illinois; we're seeing the Commonwealth of Puerto Rico declare that it can't pay all of its obligations. So, those things are stressed, and they'll continue to weigh on potentially some of the funds that they currently reside in. But overall, the credit quality of the muni market continues to grow. It's strong. Its defaults remain very low. So, overall, I think they're continuing a very strong trend.
Benz: Let's talk about what you and the team look at when you are evaluating various firms and the quality of their municipal-bond-fund lineups. What are some of the key things that you home in on?
Foos: Well, because the muni market is so large and diverse and quite fragmented, we want to make sure that we look for funds that have very strong, robust research capabilities. We look for teams that have experienced managers, a robust credit and quant staff, and pretty sophisticated tools that support them and can help them analyze the certain credit or interest-rate risks that they take on in their portfolios.
Benz: And expenses, of course, are a factor.
Foos: Of course, expenses are always factor in that.
Benz: So, you brought some of the team's favorite funds. You kind of segmented them by type. Let's start with a short-term high-quality muni fund that you like for the person who maybe has money that they expect to spend within, say, the next five years. What's a good option for someone like that?
Foos: I'll back up and say that the funds that generally check all of the boxes that we're looking for, and particularly in the muni space, tend to come from Fidelity and T. Rowe Price. We really like their muni teams; we like their muni offerings, specifically the national muni offerings there. That's because those firms have invested in their teams and in their tools. They offer pretty consistent returns and usually at a lower price point. Vanguard also, obviously known for its very low fees, has a pretty straightforward strategy when it looks at munis as well.
But specifically for those interested in a little less interest-rate risk, Gold-rated Fidelity Limited Term Municipal Income (FSTFX) is something to take a look at. T. Rowe Price Tax-Free Short Intermediate (PRFSX) or T. Rowe Price Summit Muni Intermediate (PRSMX) is also a really good choice.
Benz: How about for an investor who has a slightly longer time horizon?
Foos: Again, I would look toward the Gold-rated funds. T. Rowe Price Tax-Free Income (PRTAX) and Fidelity Tax-Free Bond (FTABX) are very good choices because, again, over the longer term, they are providing very consistent results with lower volatility and lower fees.
Benz: It's interesting--within the muni space, a lot of the issuance is long maturity, correct? And a lot of the funds are set up to focus on the long-maturity bond. So, let's talk about a fund or two that you like in that area because that is where a lot of the assets are.
Foos: For the longer-maturity bonds, we really like T. Rowe Price Tax-Free Bond again. It consistently takes a limited amount of credit risk. It really manages that and its interest-rate risk; but at the same time, again, it offers lower fees and not a tremendous amount of volatility, which I think people are really looking for in their longer muni portfolios.
Benz: I'd like to talk a little bit about high-yield munis. It's been interesting to see that even as high-yield taxable bonds have had a rough go of it recently, high-yield munis have been doing OK. Why is that?
Foos: Well, again, I think it's because some of the salient issues that have affected the high-yield corporate-bond issuers and equity issuers just aren't the same as we see in the high-yield muni market. They're not affecting the issuers in a similar manner. The steep drop in oil prices or the concern over slower growth in the emerging-markets sector really don't directly impact some of the muni sectors that we traditionally see in the high-yield space, such as tobacco or some of the lower-credit-quality hospital sectors, for instance.
Benz: Which is why they've performed relatively well. So, you've got a fund that you like in this area, but in addition that fund, let's talk about the role that a high-yield muni could serve in a portfolio. Should you think about it as kind of the aggressive kicker when you've got your core, high-quality piece built out?
Foos: Well, the specific fund that we like in the high-yield space is T. Rowe Price Tax-Free High Yield (PRFHX). We give that a Gold rating because it takes a certain amount of calculated risk and it delivers consistent results especially in down markets. As for how people should look at that high-yield fund's role in their portfolio: You're going to get a little bit more yield there--which is what you're looking for and that's good--but at the same time, you have to be cautious with that because there is risk associated with those higher yields. We want to make sure that the manager and the investor can know what those calculated risks are and how to manage that.
Benz: Beth, thank you so much for being here to share your insights as part of our Tax Relief Week.
Foos: Sure. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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