(PUB) Investing 2015

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Like their taxable-bond counterparts, munis have
been on a tear since the beginning of 2014 . The
sector benefited from the impressive rally in broad
bond market yields, led by the Treasury market, and
also from favorable supply/demand dynamics in
place for much of the year. After suffering $57 billion
of outflows in 2013, funds in the various municipal-
bond Morningstar Categories saw an estimated $29
billion in net inflows in 2014. Returns for long-
term municipal bonds were especially strong. The
muni national long-term category gained 12.5%
on average from the beginning of 2014 through
January 2015.
While such a gain is eye-catching, especially for a
category focused on investment-grade bonds, the
potential for returns is less rosy going forward. That’s
due to simple math. On the heels of last year’s
rally, the yield on the Bond Buyer GO was 3.6% as
of late February 2014, down from 4.7% in late 2013.
Even though the yield looks a bit better on a tax-
adjusted basis, that’s still meager by historical stan-
dards. Meanwhile, SEC yields on long-term muni
funds, which also often invest in short- and interme-
diate-term debt, look decidedly sparse at just 1.7%.
Yields are important because, while bond prices can
fluctuate from year to year with changes in interest
rates, a bond’s long-term return ultimately comes
from its yield, making yields a good indicator of future
total return potential.
Investors considering an investment in muni bonds
after 2014’s rally should also be taking the long-
term muni category’s significant interest-rate risk into
consideration. Like their long-term taxable counter-
parts, the prices on long-term muni bonds are vul-
nerable to big losses when bond yields rise. During
the worst of 2013 ’s muni sell-off, funds in the muni
long-term category lost 8% on average just between
May and August, helping to feed an estimated $13
billion in net outflows for the year. As a result, many
investors didn’t benefit from the sector’s impressive
rebound in 2014. There are signs, however, that 2013’s
lessons haven’t been so quickly forgotten. Overall
flows to funds across the municipal-bond categories
recovered nicely in 2014, but the muni long-term cate-
gory continued to suffer outflows into 2014.
While the category is unlikely to repeat its 2014
returns, there’s nothing to suggest that munis are
headed toward a meltdown. True, headline risk hasn’t
completely faded away: Puerto Rico’s fortunes
remain unclear, and Illinois’ new governor will have
to quickly address the state’s looming budget deficit
and pension obligations. However, most munici-
palities have seen improvements in their finances in
recent years. Tax revenues are up, and defaults hit
a three-year low in late 2014. Meanwhile, muni bonds
look more attractive when compared with Treasury
bonds. As Treasury yields rallied hard in December
and January, muni yields lagged modestly, leaving the
ratio of muni to Treasury yields—a much-watched
measure of the relative attractiveness of the two
markets—in attractive territory as of late February.
For those considering an investment in the category,
several Morningstar-rated options look particularly
attractive. Fidelity Municipal Income FHIGX, with
a Morningstar Analyst Rating of Gold, benefits
from an experienced team, deep analytics, and an
attractive price tag, while steering clear of big
interest-rate bets and treading carefully in lower-
rated fare. Vanguard Long-Term Tax Exempt
VWLTX blends super-low expenses with a straightfor-
ward approach to the market, while Franklin
Federal Tax-Free Income’s FKTIX buy-and-hold
strategy and generally high-quality portfolio has an
impressive record. œ
Contact Sarah Bush at
The Road Gets Bumpier for Long-Term
Muni Funds
Income Strategist | Sarah Bush