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Colby: Long-Term Munis Wildly Attractive

Timothy Strauts

Timothy Strauts: I'm Tim Strauts, ETF analyst at Morningstar. With me today is Jim Colby, senior municipal strategist and portfolio manager at Van Eck Global. Van Eck has a full suite of municipal bond ETFs.

Thanks for being here, Jim.

James Colby: Tim, thank you.

Strauts: Now, the municipal bond market has experienced heightened volatility over the last 12 months. What is really the state of the municipal market today?

Colby: The market is incredibly resilient, and has demonstrated that resiliency with very solid performance year-to-date. I think through the end of the third quarter going by the Barclays indices, if you take a look at those numbers, you'll see that generally munis are up over 8% year-over-year, year-to-date. That's a great demonstration of what I mean by resiliency.

We ended last year on a very sour note. As many of you know the reports that came out from Meredith Whitney about the state of the municipal bond market, sent the market into a period of decline, and we've recovered significantly well from that.

Strauts: Now I just saw Fitch ratings came out with one of their reports, and for the last 10 consecutive quarters, they've downgraded more municipalities than upgraded. So, we haven't seen the massive defaults that Meredith had propositioned, but we have seen still a lot of downgrades. What do you think is the state of the credit quality of the municipalities in general?

Colby: The marketplace is aware that economic fundamentals are pointing to a very slow, long-dated recovery from our recession. The states and municipalities, as is the typical pattern over history, are slow to exhibit the recovery. You may see evidence of recovery more prominently displayed in the equity marketplace from corporations, but for states and municipalities, local governments who have slashed budgets, who have laid people off, who are struggling with depressed revenues from local taxation, for example, will continue to show weakness, I think, over the coming months, if not over the next couple of years.

Despite the fact that, for example, the Rockefeller Foundation reports that revenues on balance are increasing, that's from a very low base. And the Fitch report as you mentioned just a moment ago, I think is evidence of the fact that there is weakness in credit quality, not the kind of weakness that would play out into Meredith's report and expectations of some $200 billion worth of monetary defaults, but a general lowering of overall credit quality in the municipal marketplace.

Strauts: Now kind of speaking to lower credit quality, we have seen that municipals have been trading at premiums to U.S. Treasuries for quite some time now, and in the past we used to always hear that any time municipals traded at a yield higher than comparable treasury, that was a great time to buy. But it has been a very long period where we have had this premium yield.

Now, is this going to be new normal of premium yields, or will eventually the market revert to the old norms?

Colby: It is the current state of the municipal marketplace. Whether or not it remains as it currently is, whether it becomes, as you say, the new norm, I think depends in great part upon what happens now with the Fed programs to manage interest rates long-term, what happens overseas to investor confidence in the survival of the euro, the survival of eurozone countries. Why is that important? Well that plays into the demand and the pricing of Treasuries. Treasuries, despite the fact that S&P downgraded the credit quality of the United States government back last summer, Treasuries remain the reserve currency of the world.

So, with the flight to quality that's occurred because of the concerns for the recession in our country, with concerns for the recession and the difficulties that the eurozone countries are having overseas, and now China evidencing some weakness in their economy, Treasuries get bid up as a safety investment vehicle, if you will.

So that changes the equation to municipals. Yields on munis move rather slowly relative to other asset classes, and the fact that their nominal yields are now, and have been for some time, north or greater than 100% of Treasury yields, I think represents the current state of the marketplace.

Now two years from now, hopefully we are past the recession concerns, hopefully we are creating jobs, hopefully the eurozone comes out of its malaise, and the Fed will cease to manage short-term interest rates, and the relationship between munis and Treasuries will perhaps go back to more normalized levels.

And of course, another big uncertainty is the election in 2012, and will we have a wholesale change in tax policy in this country? Nobody knows, but the fact that these relationships exist as they are now calls attention to the municipals as an asset class and to their attractiveness.

Strauts: When you look at the municipal market right now, what maturity ranges did you find are most attractive? Is it short, is it intermediate, or is it the long-term?

Colby: Frankly, the long end of the municipal yield curve has been wildly attractive for quite some time. Only recently I would say have the spreads, the differential between long- and short-term muni rates started to contract a little bit and take away some of that opportunity, but I would say for investors who can take a longer-term view of their investments and their commitments, long 30-year, long-dated municipal bonds are attractive.

With the uncertainty that exists, however, with respect to credit quality, with respect to the future potential rise in interest rates, once the Fed takes their foot off the brake, so to speak, we have seen, at Van Eck, we have seen attention paid to our short and intermediate ETFs because people feel much more comfortable committing not to the long-term, where there's more risk to change in valuation because of higher interest rates, but feeling more comfortable centered in the middle of that municipal yield curve where they can count on more protection of their principal over a period of time.

Strauts: Thanks for being here, Jim.

Colby: Tim, thank you very much. I appreciate it.

Strauts: I'm Tim Strauts with Morningstar. Thanks for watching.