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Why Are Muni Bond Funds Struggling?

Christine Benz

Christine Benz: Hi, I am Christine Benz from Morningstar.com. The bond market struggled during the month of November and municipal bonds were no exception. Here to provide some context behind these headlines is Miriam Sjoblom, she is Associate Director of Mutual Fund Analysis for Morningstar. Miriam thanks so much for joining us.

Miriam Sjoblom: Thank you, Christine.

Benz: So there have been some really scary headlines recently municipal bonds did have a tough month, let's talk about some of the key factors that drove municipal bond funds down recently.

Sjoblom: Well sure, one of the biggest ones affected bond funds generally and that is after the Fed announced its QE2 program. Some market participants may have been speculating well now that the Fed is trying to stoke inflation what's that's going to mean for long maturity yields. So, that could have caused some of the price declines for long maturity munis.

Benz: That's one thing that you noted that it was one of the hardest hit categories during the period?

Sjoblom: That's right. Funds in our national long term muni category lost around between 2% and 5% during the month of November.

Benz: Okay, so it sounds like also within the muni market some supply demand imbalances may have driven the securities down as well?

Sjoblom: Sure. In this the supply and demand imbalance, supply is not necessarily, this isn't unique to 2010. Supply tends to be heavier in the fourth quarter of the muni market. We saw about 3 billion to 5 billion a week in issuance this summer. During November one of the most, the first difficult month it was expected that about 12 billion would come to market.

Benz: So that was another factor depressing the prices?

Sjoblom: That's right.

Benz: One thing I want to talk about, there has been a lot written about whether credit qualities and municipalities struggles have contributed to this dip in muni prices, what's your take on that issue?

Sjobolm: Well, I mean it's a very good question. You know for starters, in another part of the supply and demand imbalance was that retail investors pulled money out of mutual funds to a very large degree. And it could be that all of the negative headlines about credit quality could have, in addition to some price volatility could have prompted some retail muni investors to take their money out. Retail investors are a huge part of the municipal bond market. It's a little different from the taxable bond market where retail investors own about two-thirds of the municipal bonds markets. So it could have an effect on impacting investors' perceptions.

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Benz: This is an issue I want to come back to and it's one we've talked about before Miriam this whole issue of municipality struggles though their financial problems are real, should that be a concern for muni investors or do you think it's a little bit overblown?

Sjobolm: Well I think, it is important to stress that municipalities are going through a very difficult time. However I do think some of the concerns that are  prompting very scary headlines like municipal bond is the crisis is the next shoe to drop.

Some of the issues, particular issues that get focused on in the media whether you are talking about an incinerator in Harrisburg, Pennsylvania or a steam plant in Menasha, Wisconsin or the Las Vegas Monorail. These are first of all very small parts of the market, but they are sort of non-essential, high-risk projects that the muni market is already well aware that these issuers were going to be in trouble for years now. So this is really not news to the muni market, these particular issuers that seem to get so much attention in the press.

Benz: So if I am looking at municipal bonds or maybe I own them in my portfolio through a fund, are there any things I should be on the lookout for any things that you would consider particularly big red flags for muni investors at this point?

Sjoblom: Well, it's really interesting because there is so much focus on credit quality and I really think for a portfolio that's diversified across hundreds of municipal bonds and also supported by a team of a dozen very experienced researchers, you have, you probably don't have to worry about credit blow ups in your portfolio.

A bigger issue is this environment of low yields has many investors reaching for yield and very hungry for yields and some of the highest yielding funds in the long-term muni category do use leverage, they use inverse floaters to get exposure to leverage exposure to long-term bonds.

If you look at the funds that performed the worst during November, they were funds that do use leverage. So if this is an environment where there's going to be more volatility after we had a just nonstop inflows into muni bond funds since the start of 2009.

If we are going to see retail investors, if their demands are going to be more in fits and starts going forward you can expect more volatility. If you don't want that volatility you don't want to have a leverage fund.

Benz: So in terms of identifying this in a portfolio should I – do I have to scrutinize holding-by-holding or what kind of disclosure do I get as a shareholder or perspective shareholder?

Sjoblom: Well, I think there are some fund shops that completely have made the decision to not use those kinds of tools at all, in their portfolio like Fidelity, T. Rowe Price, Vanguard. These are, you pretty much can count on being free of those types of tools.

You can either find this information by looking at a fund company's fact sheet and information on their website. If you don't see it there, that doesn't mean it's not there. Sometimes the best way to do it is just to open up the Annual Report and do a search for inverse floaters or tender option bonds they are also called.

Benz: Okay. It also seems like as with any bond fund a much higher yield than competing funds would also be kind of a red flag.

Sjoblom: That's right. I think anytime you're using, looking at the highest yielding fund in a category, you want to be – you are going to have to do some more due diligence, some more investigation.

Benz: Okay, well, thanks Miriam, helpful insights. We appreciate you being here.

Sjoblom: You're welcome.

Benz: Thanks for watching. I am Christine Benz from Morningstar.com.