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Value in Long-Term Muni Funds

Christine Benz

Christine Benz: Hi, I am Christine Benz for Morningstar.com. In a 60 Minutes episode that aired in late 2010, bank analyst Meredith Whitney warned of a coming spate of muni-bond defaults amounting to hundreds of billions of dollars.

Here to discuss the current state of the muni market is associate director of fund research, Miriam Sjoblom.

Miriam, thanks so much for being here.

Miriam Sjoblom: Thank you, Christine.

Benz: So has that doomsday scenario for municipal bonds borne itself out so far this year? What are you seeing in the muni market?

Sjoblom: It just hasn't so far. I think we're on track to some predictions I've seen. Say, by the end of the year, maybe we'll see a little more than $1 billion worth of defaults this year. That's a far cry from hundreds of billions of dollars, and we just haven't seen any new huge issuers come and say, "we are in danger of not being able to pay our debts." And actually, if you compare with previous years, the trend, the default rate has actually been coming down in 2011.

Benz: So that's kind of surprising there. Investors, I think, were battening down the hatches and really selling munis in late 2010, into early this year. How has performance been? Has it translated into fairly decent performance?

Sjoblom: Well, it's stayed rough through January, but since then, we've seen a pretty big recovery for municipal-bond funds. And in general, long-term funds sold off the most from November to January. So, they've kind of had the biggest bounce this year, gaining for the year to date around, anywhere between 5% and 9%, depending on the type of strategy. Intermediate funds have done well, gaining around 3%-8%. So, you've seen really strong returns despite all the warnings at the beginning of the year.

Benz: So, have investors been getting back into munis after dumping them late last year and early this year?

Sjoblom: It's interesting. That was one of the reasons cited for the poor performance in the municipal-bond market. It was just that huge amount of outflows late last year and earlier this year. Now, flows have stabilized somewhat, and we started to see inflows into short and intermediate muni funds. We've actually still seen outflows from long-term funds as a group. So, I'd say, flows have stabilized, but they haven't really picked up. So, despite the fact that perhaps these credit concerns were overblown, you haven't seen a lot of investors coming back into the market.

Benz: You wrote a really interesting piece, Miriam, in Morningstar FundInvestor, where you talked about what you think could be a potential opportunity in long-term municipal-bond funds for people who have a sufficiently long time horizon. I'd like to talk about your thesis there and why you think they could be attractive for certain individual investors?

Sjoblom: Sure. As I mentioned, long-term funds have remained unloved. And it used to be, the long-term would be kind of the flagship fund at a fund shop because muni investors wanted income, and that's generally where you got the most income. But there's been so much volatility in early 2008 and late 2008, and since then, it seems like investors have made this trade-off in which they would rather have less volatility and accept less income for that.

So you've seen actually that intermediate funds as a group, have overtaken long-term funds in size. So, as a result, you've seen that yields on intermediate munis have really come down significantly. Some managers are making an argument that there's just not a lot of value in that area. So, you really are making a trade-off. If you want that less volatility, there's absolutely good reason to not want a very volatile offering, but there might be some value in the long end of the yield curve.

Benz: And one of the reasons you keep mentioning the role of funds and inflows and outflows is that, in contrast with some other market sectors, mutual funds are actually very big players in the muni market, right?

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Sjoblom: That's right. Retail investors, in general, whether they're buying munis directly or through mutual funds, are a very significant size of the market, around two thirds of the market. So, what retail investors are doing and what they think of munis, whether they're attractive are not, can have a big impact on the market.

Actually mutual funds are some of the only real natural buyers of long-term munis. You just don't see as much demand for long-term munis. They're very long duration, and who wants a 30-year bond? Banks don't have liabilities that long to offset, and the same goes with property and casualty insurers. Pension funds do have long-term viabilities, but they don't get the tax benefits from the munis.

So, just in general, there is less demand for long-term munis. One interesting thing, typically over the past two decades or so, you'd see the difference in yields between say a 10-year muni and longer, like 22- to 30-year munis; usually that would be around 80 basis points. On the high end, it might go out as high as 120-150. In the financial crisis, what we saw was it blew out to 200, and with this latest sell-off, November through January, we saw it reach that level again.

So you've got this historic gap. You're getting that much extra yield to go out longer. It seems to make sense to invest with the fund that has the flexibility to take advantage of those opportunities.

Benz: Right. I also wanted to talk about the more credit-sensitive muni funds. I know the high-yield muni funds have more attractive yields but obviously a lot more downside-risk potential, too. How have you seen that category perform?

Sjoblom: In general, high-yield muni funds have performed about the same as intermediate- and long-term funds this year. So there's actually a wide degree of difference within categories, but among those three categories, you've actually seen the ranges are about the same. But as far as defaults, if you are concerned about defaults, those are the funds that are going to have the most trouble. It's not really going to be the high-quality, general-obligation issuers. It's going to be the land-development deals in Florida. That's where you've really seen the most defaults in the municipal-bond market in the past several years.

So, there are still some investors out there who are very happy to get as much yield as they can. Some of the most aggressive high-yield bond funds still have the most assets, but I think it's just as important for investors to understand what they're getting and the risk of those funds.

Benz: Are there any other risk factors that muni investors should be attuned to right now?

Sjoblom: Well, you know, I think after a rally like we've seen, performance has been strong this year for munis. A big reason for that has been that the level of supply, the amount of new issuance in the market, has been very low. One estimate I saw predicted this will be the lowest level of issuance since the year 2000. So what that means is you've seen a rally, and it hasn't been because there has been a lot of strong demand from fund investors, but it's because there hasn't been a lot of supply. So that's one of the big drivers behind the strong performance this year.

But we know that several issuers are planning to come to market. Just for example, California normally has a multi-billion-dollar issuance in the spring. The state didn't do that this year, while it was sorting out its budget situation, but the state is planning to come with a couple new general-obligation issuances in September. When you have new issuance after a rally and you've got muni yields at the lows they are at now, rates are going to have to rise a little bit for investors to have the appetite to want to invest.

So I think this is something we've seen happen. It happened in late 2010 and late 2009. It's just kind of the supply-and-demand elements of the market, and I think investors get surprised when they see any losses. They are less surprised when they see very strong gains in their muni funds, but it's all kind of the different sides of the same coin.

Benz: So, last question for you, Miriam. Investors often wrestle with whether to stick with their own state's municipal bonds and municipal-bond funds or go with a national fund that's geographically diversified. What's your counsel to investors who are wrestling with that question?

Sjoblom: Well, to say first, if you are concerned about credit quality, I think the most possible diversification you're going to get is to go with your national fund. So, even if you are in a state, you could consider diversifying by having some holdings in the state and some holdings in a national fund. But I would say that a state like California has a very, very large and relatively liquid municipal-bond market.

And so you can get pretty good diversity of issuance in the state of California, and there is lot of demand both from national muni investors and in-state investors for California bonds. But a state like Michigan, which has longer-term challenges and whose economy has been struggling since well before the recession, there is just not as much diversity of issuance in a state like that. You should really consider going with the national fund.

Benz: Okay, well, thanks, Miriam, always great to get your insights into this sector. We appreciate it.

Sjoblom: You're welcome.

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