Munis and TIPS Beckon

A version of this article was published in the February issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

As most equity markets surged to record highs in 2013, the summer sun burned the bond market. It was a challenging environment for many fixed-income funds in 2013, as the broad-market benchmark Barclays U.S. Aggregate Bond Index lost money for the first time in more than 15 years. Then-Federal Reserve chairman Ben Bernanke rattled the bond markets with his announcement in May that suggested the Fed would start to taper its purchases of bonds sooner than expected. That prospect sent ripples throughout the bond market, and many fixed-income sectors took it on the chin during the summer months and haven't fully recovered.

Among the worst-performing areas of the market were inflation-protected and municipal-bond funds, as other factors specific to those sectors further exacerbated the losses from the broader sell-off. Given that backdrop, and drawing on inspiration from Russ Kinnel's annual "Buy the Unloved" approach to the equity markets, there's a case to be made for a buying opportunity in those areas. Both categories experienced significant outflows in 2013, to the tune of $29 billion out of inflation-protected bond funds (25% of category assets) and $58 billion out of the overall municipal-bond fund universe (10%). Indeed, investors hitting the exits in droves were themselves a contributing factor to the categories' weak performances, as fire sales in the midst of the sell-off put additional downward pressure on prices in those two relatively illiquid markets.

That was particularly true of muni-bond funds, where mutual funds are big players in the market, and the selling pressure significantly affected pricing. What's more, the Detroit bankruptcy filing and turmoil in the Puerto Rican debt markets weighed on returns and caused additional bouts of volatility. Funds in the muni-national long and high-yield muni Morningstar Categories were hit the hardest, but all U.S. municipal fixed-income categories lost money in 2013. Sell-offs often create opportunities, though, and as of late, municipal bonds have looked relatively cheap compared with Treasuries on a historical basis.

Factoring in the tax benefits of owning munis, meanwhile, may make this an opportune time to add exposure. While there may be additional future volatility in the market and munis do have interest-rate sensitivity, there are several funds that may be a good fit for those with a long time horizon. The team from Fidelity, led by veteran Mark Sommer, offers a straightforward and careful approach to the muni markets via  Fidelity Municipal Income (FHIGX) and  Fidelity Tax-Free Bond (FTABX). These funds, both with Morningstar Analyst Ratings of Gold, eschew leveraged structures and tread carefully in the muni market's diciest names. As expected, Fidelity's muni funds held up relatively well during the sell-off and over the long term. The team backing these funds has provided investors with a relatively smooth ride and solid returns.

Vanguard also provides relatively conservative exposure to the muni market at rock-bottom prices through its family of tax-free funds, including Silver-rated  Vanguard Intermediate-Term Tax-Exempt (VWITX) and  Vanguard Long-Term Tax-Exempt (VWLTX). The funds' low expense ratios mean that Vanguard doesn't need to stretch for yield by loading up on risky, low-quality credits or by employing leverage. Instead, the team aims for the middle of the road with a high-quality portfolio, relying on its cost advantage to beat the competition.

Even when after-inflation (real) yields on Treasury Inflation-Protected Securities turned negative in recent years, many managers still argued that expectations for the eventual onset of inflation justified keeping money in the category, particularly over comparable Treasury bonds. As of Dec. 31, 2013, the backup in rates meant that after-inflation yields across the curve landed in positive territory, while inflation-expectations--derived from pricing differences between TIPS and conventional Treasuries--remained slightly below the historical average. For example, pricing differences at year-end implied an expected rate of inflation of roughly 1.7% during the next five years.

If one believes that inflation will be higher than 1.7% annualized during the next five years, now may be a good opportunity to invest in an inflation-protected bond fund. Volatility may well persist and interest-rate risk remains a factor, but TIPS offer an explicit link to inflation and can play an important role in a diversified portfolio. Compared with other inflation-sensitive asset classes such as commodities and REITs, TIPS have exhibited less volatility over longer periods of time. Proven funds worth considering here are  Harbor Real Return and  PIMCO Real Return , Both Gold-rated funds are managed by PIMCO's head of real-return portfolio management Mihir Worah, who looks to obtain cost-efficient exposure to TIPS and other inflation-linked bonds by seeking better execution than passive investors. At times, he will make out-of-index bets in high-yield corporates and non-U.S. developed- and emerging-markets debt, for instance, taking advantage of PIMCO's tremendous depth. Those types of allocations have made the fund consistently more volatile than the average inflation-protected bond fund (as measured by standard deviation), but its record during Worah's tenure is still one of best when accounting for risk.

For cheaper and more benchmarklike exposure, Gold-rated  Vanguard Inflation-Protected Securities (VIPSX) is another solid option. By keeping the fund close to its benchmark, lead manager Gemma Wright-Casparius lets the fund's rock-bottom expenses do most of the heavy lifting. Its 0.20% fee is among the lowest in its category and well below the category median of 0.65%. Over the long haul, simplicity and low costs have been a good combination, and the fund's trailing five- and 10-year returns through Dec. 31, 2013, have beaten more than 75% of its peers.