Note: This video is part of Morningstar's February 2015 Tax Relief Week special report.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. Municipal bonds enjoyed tremendous performance in 2014, but can they continue their run? Joining me to discuss that topic is Beth Foos. She is a senior analyst with Morningstar. Beth, thank you so much for being here.
Beth Foos: Thanks for having me.
Benz: Muni bonds had really great performance in 2014. There was some doomsaying heading into the year. What were the drivers, in the end, behind relatively strong returns from munis last year?
Foos: You're right. Despite expectations, muni funds did have a really strong 2014, both in terms of [fund flows] and in terms of returns. I think that was due to several different factors. Interest rates remained relatively low as well as municipal default rates. And overall, credit quality in the muni sector was improving, although slowly; but it was improving, making those bonds relatively attractive. At the same time, new issuance for bonds was low. It was down, so it kept the supply of muni bonds low at the same time that demand was building.
Benz: Looking forward, do you see catalysts for very strong performance from munis over, say, the next few years or are valuations such that munis may not be as attractive in the future as they have been in the recent past?
Foos: I think they did enjoy a very strong 2014, and we do see some of those trends continuing into 2015. Even in the early part [of the year], we've already seen some of those similar trends for funds; but with that, we're going to be keeping an eye on, again, the muni-bond-issuance levels as well as those long-term interest rates because we do expect that they might increase in 2015 at some point and, therefore, interest-rate-sensitive funds might get stung a little bit.
Benz: So, I want to talk about that because a lot of the issuance in the municipal-bond space has historically been long term. So, are munis particularly vulnerable in a rising-rate environment? What's your take on that question?
Foos: With this one, I think it is important to know that, just like in the taxable space, in the muni space, there are certain funds that do aim to deliver more interest-rate risk and less interest-rate risk. So, Morningstar tries to help investors identify which funds are doing that based on our category designations. So, we divide our muni funds into short-, intermediate-, and long-term categories as well as a high-yield category to give investors an indication of what that fund is actually aiming for either in terms of interest-rate risk or credit-quality risk. With that said, the funds in our long-term category generally are more sensitive to rate changes. And in 2014, when rates fell, that rewarded longer-maturity bonds, funds with longer durations and that took on more interest-rate risk. And conversely, when those rates rise, the funds in our long-term municipal-bond category might be a little bit more vulnerable to losses than their short-term and intermediate-term counterparts.
Benz: So, in addition to the interest-rate worries, another set of concerns hanging over the muni market over the past few years has been the threat of additional defaults. We saw Puerto Rican bond problems as well as Detroit's bankruptcy. Let's talk about, from a default perspective, how the muni landscape is looking to you and the team today.
Foos: That is true. We have seen a lot of those struggles grab the headlines recently, namely the state of Illinois and their pension issues; Puerto Rico, as you mentioned; the city of Detroit's bankruptcy--and in that case, investors actually did have to take an adjustment to their investment recovery, which hurt some funds and definitely some investors. But overall, again, I think it's very important to remember that, historically, default rates from municipal bonds have remained extremely low, especially when compared with corporate bonds. And we expect that to remain the same.
Benz: One of the things you focus on is the mutual fund landscape. And for investors who are attempting to invest in municipal-bond funds, what should they be looking for in a firm when they are attempting to gravitate toward the funds that will be the better performers?
Foos: Because there is such a vast universe out there of municipal debt, issuers, varieties of securities and structures, we really think it's important to do solid, thorough research before making those investment decisions.
Benz: So, don't just focus on the highest-yielding funds.
Foos: Right. We like to see firms that really invest in their research team, experienced analysts and portfolio managers that know the space well and are supported by the tools and technology they need to do their jobs well.
Benz: So, if I'm looking for a muni fund and maybe I've got a short-to-intermediate time horizon, maybe fewer than five years as my holding period, can you recommend a fund--one of, say, Morningstar's Gold-rated funds--that kind of fits within that holding period?
Foos: Sure. One of the firms that does that research component well in addition to providing investors with some downside-risk protection and lower fees is Fidelity. They have been investing in their team over the last several years and their processes, and that has resulted in several of their funds getting that Gold rating over the last several years. One of those funds, in particular, is the Limited Term Municipal Income fund (FSTFX). As a part of Fidelity's offerings, I really do think that that fund or their Intermediate Term Municipal Income fund (FLTMX) also would be worth a look. Both of those funds have provided, again, solid returns at low fees for their investors, which has served them well for the last couple of years.
Benz: So, the intermediate-term fund would be better suited to someone with maybe a little longer time horizon--is that correct?
Foos: That would be correct.
Benz: There are also more credit-sensitive muni funds on the market, those that would focus on the high-yield space. Should investors use those as core-type holdings or should they think of them as more supplemental holdings to the kinds of core funds that you've just discussed?
Foos: Well, I think it would be very tempting because, again, in 2014 we saw returns rewarded for the longer-term municipal funds, as well as the high-yield space. Investors kept reaching for yield, and so we saw a lot of demand for those high-yield muni funds. I would still recommend that people keep that as a supplemental part of their muni-bond core portfolio.
Benz: Beth, thank you so much for being here to give us the lay of the land in munis.
Foos: Thank you so much.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.