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4 Bond Funds for Your Taxable Account

Christine Benz
Miriam Sjoblom, CFA

Christine Benz: Hi, I'm Christine Benz for It's Tax-Relief Week on, and joining me to share some top municipal-bond fund picks is Miriam Sjoblom. She is associate director of fund research for Morningstar. Miriam, thank you so much for being here.

Miriam Sjoblom: Glad to be with you, Christine.

Benz: First, I'd like to ask a really basic question: Why are municipal-bond funds and bonds often touted as a good fit for peoples' taxable accounts?

Sjoblom: Well, this is unique to municipal-bond funds. Their interest is exempt from federal income tax, and in many cases, if you live in a certain state, your interest is exempt from state income tax, as well.

Benz: So if you buy a bond issued by your home state or if your fund is dedicated to bonds from that home state, some or all of that income might be exempted from state income tax?

Sjoblom: Right. The biggest specialty states--they're called specialty--are New York and California. So, oftentimes, you find residents of those states like to buy bonds issued in those states.

Benz: Miriam, I'm wondering if you can kind of summarize munis today? We had a really nice rally, especially in some of the lower-rated munis in 2012. As you look forward and think about some positives for the category as well as where the challenges lie, let's talk about them.

Sjoblom: Sure. Well, with some of the challenges, it's similar to the challenges we're seeing across the bond market. After a rally like we saw in 2012, you're starting the year 2013 with yields at very low levels, and a lot of the return last year came from price appreciation, not income. So, starting at an already very low level of yields, there's very little room for yields to drop further.

Benz: So that's the negative side. Any reason for optimism as you look forward and think about states' finances perhaps.

Sjoblom: Well, there are a couple of reasons for optimism. They're more related to the technical dynamics of the market. Last year, we also saw a lot of demand into mutual funds especially. We had about $50 billion coming into muni funds altogether. So that seems to be remaining strong so far. Just in January, we had another $7 billion coming into muni-bond funds, and they're going mostly into intermediate funds as well as some high-yield muni funds. So, if investors continue to like the tax exemption and the benefits of muni funds as they have been, that will be supportive of the market.

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Benz: And one thing you've noted before Miriam is that in contrast with the taxable-bond market, muni-bond funds are actually a really big percentage of the marketplace.

Sjoblom: That's right. Retail investors are huge buyers in the muni market, more so than in the taxable-bond market, where you have a broader and more diverse investor base.

Benz: And you also have noted that there is a supply issue going on in the municipal market, as well.

Sjoblom: That's right. There seems to be a reluctance on the part of municipalities to be starting a lot of new capital projects in this sort of uncertain economic and political environment. So you're seeing a low level of net new issuance. So you have all this demand coming from retail investors coupled with not a lot of new supply out there available.

Benz: So, we are going to drill into some of the favorite fund picks from you and from the fund analyst team. Let's start with municipal-bond funds that are favorites that you consider sort of core-type investments. Maybe that are a little bit conservative, a little bit safer.

Sjoblom: Sure. I think the intermediate municipal category is a good place to look for the more core, safer type muni funds, and one of our favorites that we [assign a Gold Morningstar Analyst Rating to] is Fidelity Intermediate Municipal Income. And Fidelity is just a great well-rounded municipal-bond effort. They've got a great credit research team and experienced portfolio managers and traders. And also they've gone farther than other competitors in building out a set of quantitative analytics. So they are looking at the market from all these different angles, and they are more conservative than many other options out there.

This fund, in particular, has performed about middle of the road in recent years because the environment has rewarded risk-taking, so I think that can be a good sign. When the environment becomes less friendly, this is the kind of investment that you want to be in.

Benz: How about another core-type muni-fund pick?

Sjoblom: Sure. I'd say T. Rowe Price Summit Municipal Intermediate, and the story is very similar there. Not quite as conservative as Fidelity, but still fairly conservative. It still has been a middle-of-the-road performer in recent years. But again, the research staff, the portfolio management staff is very experienced, and they don't take a lot of chances.

Benz: If people feel that they have that core part of their muni portfolio filled out and want to take a little more risk by being in something a little more aggressive, let's discuss a couple of funds that might fill that role.

Sjoblom: Sure. One would be Vanguard High-Yield Tax-Exempt, and even though it has "high-yield" in the name, it doesn't fall into our high-yield muni category because it's relatively conservative compared with those [in the high-yield category]. So, it is in the intermediate-muni category. It's got about a little less than one fourth of its assets in bonds rated BBB and below, including nonrated bonds. So, it takes a little more credit risk than your typical intermediate-muni fund, but not so much that you need to be worried. Vanguard is very committed to diversification. You have the very low fees on the Vanguard funds, which for long-term investors are really tough to beat.

Benz: [Do you have] another noncore, sort of opportunistic pick that you can give people?

Sjoblom: Sure. This would be T. Rowe Price Tax-Free High Yield, and this fund is a high-yield muni fund, and it hasn't been one of the very best performers in recent years, but that's OK because I think it really demonstrates the discipline of the process there. It has been a great performer in absolute terms just because high-yield muni funds have done very well, but the manager, Jim Murphy, doesn't go out on a limb in sectors that are particularly dicey like tobacco-settlement bonds. He doesn't use leverage, which is a common tool in that category. And lately, the money that has flowed into the high-yield muni category seems to be gravitating toward the highest-yielding funds, which especially after a year like 2012 where they performed so well, I think it can be a risky proposition to be chasing yield that way. So, if you want more of a core, middle-of-the-road, very grounded on bottom-up research process, then I think this is a good choice.

Benz: So it sounds like you're saying, overall, do your homework, don't just focus on those funds that have the highest yields attached to them.

Sjoblom: That's right.

Benz: Miriam, thank you so much for being here and sharing the specific investment ideas.

Sjoblom: Thank you, Christine.

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