Monday, October 17, 2011

Bond Stars

Muni Bonds Are Stars, for Now

DESPITE warnings of defaults near the start of this year, municipal bond funds have turned in a Cinderella performance so far, even as many stock funds lost ground.

Total returns for some muni funds were in the 10 percent range for the calendar year, although their 12-month returns were generally lower. Analysts and fund managers see continued good performance for intermediate and long-term muni funds, along with periods of high volatility.
Miriam Sjoblom, lead bond fund analyst at Morningstar, said, “Muni bonds have had a great year, but yields across all levels are near all-time lows.” As a result, she said, “yields are likely to rise, so prices could fall.”
Many fund shareholders have been “buying and selling at the wrong time,” Ms. Sjoblom said. There was a surge of sales last November, December and January, she added, amid fears that state and city fiscal woes could lead to waves of defaults. That hasn’t happened, and, she said, the funds have turned in “a great performance since then.”
Still, muni bond funds had a net outflow of $1.01 billion in August, the Investment Company Institute said late last month.
In Ms. Sjoblom’s opinion, the funds are appropriate for anyone seeking tax-exempt income in a regular account, not a retirement account. Investors should be prepared to hold them at least a year, or preferably several years. Given today’s low-yield environment, she said, investors should focus on no-load funds with low expenses, like those from Fidelity, Vanguard and T. Rowe Price.
Investors should be aware of three other considerations when choosing a muni fund:
• Interest paid by state and local governments and agencies is generally tax-exempt for in-state residents, but when people own bonds from another state — say, a Californian who invests in Texas bonds — their home states often tax the out-of-state interest. So many fund groups offer state-specific funds.
• Capital gains that are incurred either when a portfolio manager trades holdings — or when an individual shareholder sells — are taxable.
• Some municipal bonds, while exempt from regular taxes, are not exempt from alternative minimum taxes, so investors who face a perennial A.M.T. obligation should select funds with little or no A.M.T. exposure.
Regina Shafer, who manages three municipal bond funds — short-term, intermediate-term and New York — for USAA in San Antonio, another no-load, low-expense organization, said, “Our goal is to provide as much tax-free income as possible and to try to be very tax-efficient and avoid taxable capital gains.”
The market has changed greatly since 2008, she said. Before that disastrous year, she said, muni bond insurers guaranteed bonds’ triple-A ratings, “so an investor didn’t have to think” much about individual holdings. Now credit research is important, she said, and there is more interest-rate volatility, which brings opportunity.
Ms. Shafer called muni bonds “a safe asset class” over all, pointing out that municipalities have taxing authority, unlike corporate issuers. Yields on munis in the 10- to 20-year range are actually higher than those of comparable Treasuries, which are taxable, making many munis very attractive right now, she said.
In a similar vein, Jason T. Thomas, chief investment officer of Aspiriant, a national fee-only wealth management firm, said, “By almost every measure, municipal bonds are priced attractively relative to U.S. Treasuries and U.S. corporate bonds.”
He contends that concerns about munis are overblown. The market is diverse, he said, and defaults have historically been rare, with 10-year cumulative default rates for all municipals of less than one-tenth of 1 percent.
Aspiriant uses short-, intermediate- and long-term municipal funds from Vanguard and a commingled separate account for clients.
In the high-yield part of the market, research and active management are crucial, he said, and his firm uses the Nuveen High Yield Municipal Bond fund, which Morningstar says had a total return of 10.05 percent for the first nine months of this year.
The 10-year cumulative default rate for high-yield munis is just over one-half of 1 percent, he said, citing studies that have found that muni defaults often share these characteristics: They are issued by smaller entities for risky or nonessential projects like a municipal golf course, are not rated, or are rated by only one rating agency and are nongeneral obligation bonds.
On the other hand, he said, these factors reduced the risk of defaults: a low current cost of debt service, opportunities for increased revenue like raising property taxes, efforts by governments to cut expenses, and the relatively high security of states’ general obligation bonds. And while states’ costly obligations for their pension plans are often cited as a worry, he said those obligations are long term in nature, giving plan sponsors time to make needed adjustments.
Barnet Sherman, portfolio manager of the TIAA-CREF Tax-Exempt Bond fund, called munis “a tremendous value, a core part of a fixed-income portfolio.” His fund holds only investment-grade issues, no junk. The best returns come from long-term investments, he said, adding that munis are desirable because they finance schools, ports, hospitals — “the fabric of a community.”

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