Sommer: Munis Still Attractive for More Than Just Yield

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser.

Investors have been funneling money into municipal bond funds over the last 12 months, but are there still opportunities in the sector?

I'm joined today by Mark Sommer. He is a portfolio manager at Fidelity, to answer some of these questions.

Mark, thanks for joining me today.

Mark Sommer: You're very welcome.

Glaser: Let me start off by asking, on a tax-equivalent basis, how attractive are munis today given the run that we've seen over the last 12 months?

Sommer: I think it continues to be very attractive, especially for those in the highest tax bracket, but there are many ways to look at it.

I think one of the traditional ways that investors have viewed the relative attractiveness is by comparing triple-A muni yields to Treasury yields, which I think is a little bit of an obsolete notion at this point.

A way that I like to think about it is just looking at the yields on investment-grade muni funds relative to investment-grade taxable funds, and of course you need to make adjustments for quality and duration. So it's not always easy to get very good comparisons there, but if you look at those relative yields munis look quite compelling relative to taxable investment grade bond funds at this point in time.

I would add to that that there are good reasons to own munis even independent of the ... tax equivalent yields, and that is due to their diversification benefits and their relative safe haven compared to other fixed-income sectors.

Glaser: Certainly, you said that they're safe haven, but there are some risks. One being rising interest rates. The Federal Reserve seems pretty committed to keeping those rates low for a while, although it seems like they might rise eventually. How are you protecting against those rising interest rates, and what impact do you think rising rates would have on the muni market?

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Sommer: Well, this is a question that we obviously get a lot, especially at this point in time. It's clearly the case that if we were to see all interest rates rise, that would be bad for bonds, but decision-making around this is tricky, and it's tricky for a couple of reasons.

First, I would say that not all interest rates are created equal. That is, if the Fed raises short-term taxable rates, that doesn't necessarily mean that long-term muni rates, especially long-term muni bonds, let's say, with some credit spread, are going to go down in price. In fact, there is still some room for price appreciation among long muni, let's say health care and other sectors that are kind of mid-rated sectors, and that's because the muni yield curve is so steep and because the spreads are still very generous.

The second issue is that timing is notoriously difficult. For those who have been anticipating rising rates for the last three years, they've missed out on very good bond returns, especially in 2011, where we saw double-digit muni bond returns.

So getting that timing right is quite difficult, and in fact philosophically in our funds, we don't try to call the direction or timing of interest rates. If shareholders want less interest rate sensitivity, then they can buy our shorter maturity products, a short-immediate fund or intermediate fund, and we don't want to second-guess them by, let's say, lowering the duration of our long muni national fund.

That said, there are a few things we can do to mitigate the impact of rising rates in our funds. The key one is how we're positioned along the yield curve. We would expect that if rates rose, that long-term rates would rise less than short-term rates, which is where the Fed has the most control, and that what we call a barbell structure, where we're overweighting shorter-term bonds and longer-term bonds, is going to outperform in that type of rising rate environment.

The other thing that we do is we've been keeping more liquidity in the funds and the idea there is that if and when rates rise, we would expect because of the decline in the market associated with that, that we would see shareholder outflows. So, we want to be able to accommodate those outflows in a way that's not disruptive to the shareholders that stay with us.

Then finally the third thing that we do is we often overweight higher-coupon structures in our portfolios, which we have seen outperform in rising-rate scenarios, and so that's another way that we can--without changing the overall interest rate sensitivity of the funds--that we can help to mitigate some of the impact on our shareholders if and when rates rise.

Glaser: Then turning to credit risk, certainly across the credit spectrum, munis have held up very well, better than a lot of investors have expected. Are you seeing more opportunity in the very highly rated triple-A sector, or are you seeing better opportunities lower down that scale?

Sommer: I would say that the market has changed a lot in the last five years, and it has been disrupted in the sense that we've seen the disappearance of triple-A munis and the homogeneity that that gave the market and apparent credit transparency that retail investors thought that they had from those triple-A ratings. Whereas now the market is more of a mid-rated investment-grade market with lots of names that investors don't necessarily recognize. That's where our bread and butter is, is understanding this broad market with our research capability, and using our trading capability and the technology that we have to scour the market, to sift through all the offerings in the market, and to find more mid-rated types of credits where we are being compensated for their lack of recognizability, if you will, in the more retail-driven demand areas of the market, where mom and pop are going out and buying individual bonds.

Glaser: So taking a look at supply and demand: Are you seeing an imbalance between the number of new muni issuances that are coming into the marketplace versus the large investor demand for municipal investments over the last 12 months?

Sommer: I would say over the last 12 months that's been the primary driver of performance in our market. The relative lack of supply compared to, after investors got over the initial scare of "we are going to see hundreds of billions of dollars in defaults in our market," which was at the beginning of 2011, and it didn't play out that way. Investors got more comfortable with the municipal market, and we saw significant inflows not just into funds but individual bonds, retail demand, and relatively light supply in our market. Some of that was due to the surge in issuance that we saw primarily due to the Build America Bond program at the end of 2010, but that program expired. In some ways, it allowed issuers to prefund some of their capital needs, and then in 2011 as supply declined and was out of balance with that demand, we saw tremendous muni performance.

Glaser:  Now we have been hearing increasingly from investors that they are getting hit by the AMT. What advice would you have to muni investors in particular who are being hit with the alternative minimum tax?

Sommer: Well, this is another question that we get a lot. They will ask us what percentage in our funds do we own that's AMT. I think that what investors need to keep in mind is that even those who pay the AMT, it might make sense to buy AMT bonds either individually or through funds. The reason is that in a relatively low-yield environment, what we see sometimes is that AMT bonds come to market at 20% to 30% yield premiums relative to similarly rated bonds that aren’t subject to the AMT. So ... even if you're an AMT payer, you are being almost fully compensated for the taxes that you would incur by buying those bonds. And they have other benefits for the funds. AMT spreads can tighten. There are certain diversification benefits, both in terms of sectors and individual issuers.

So, though we own relatively little across the Fidelity funds in AMT--and in many funds, it's less than 5%--this can make sense even for AMT shareholders. And for non-AMT shareholders, it's extra yield that they get without incurring any more risk in a lot of cases.

Glaser: Mark, thank you for joining us today.

Sommer: You are very welcome.

Glaser: For Morningstar.com, I'm Jeremy Glaser.