(08/27/13) What's Next for Munis?

The Detroit bankruptcy has caused investors to worry; in fact, for three months now, munis have been among the worst performing sectors of the US fixed income market, observes Mark Salzinger, editor No-Load Fund Investor.

We would urge you not to overreact to the volatility in the municipal bond market. After the recent losses, municipals are more attractive than they have been in quite some time.

We see no problem with their constituting significant portions of your fixed-income exposure, especially if you are in a high tax bracket.

Despite the fiscal problems in Detroit and some other cities, we believe that interest rate risk, not credit risk, is the biggest risk municipal bonds face now. In fact, with some notable exceptions, the fiscal situations among states and localities have improved markedly over the past several years.

First, revenue has been increasing. For example, the US Department of the Census reports that state tax revenue in the first quarter of 2013 increased by nearly 10% year over year, with individual income-tax receipts leading the way with a gain of almost 20%.

For the 12-month period ended March 2013, total state tax revenue reached $821 billion, up from $789 billion in the previous 12-month period. Adding in local tax revenue, the sum for the year ended March 2013 comes to $1.42 trillion, versus $1.35 trillion for the year prior.

Second, spending has been restrained in many jurisdictions. Combined with the greater revenue, this is resulting in the expectation of budget surpluses for 2013 in many large states, including Texas, Ohio, and even California.

The damage to municipal bond prices has been so severe over the past several months, that yields within the sector exceed those of Treasury bonds with similar maturities, even though municipals offer tax advantages to individual investors.

Especially for investors in high tax brackets, municipal bonds offer significant after-tax advantages in yield.

Municipal bonds are funded either by general tax revenue, or by fees associated with certain municipal projects and facilities, such as schools, hospitals, and toll roads.

The former are called General Obligation (GO) bonds, while the latter are generally called revenue bonds. In the old days, GOs were considered safer, because they were backed by the full taxing authority of the issuer. Now, revenue bonds are more in vogue.

After all, there might even be specific projects in Detroit that are solvent, with associated solvency for the bonds that funded them.

In a rising-rate environment, it makes sense to limit your exposure to any type of long-term bond.

So, if you want to decrease your risk while harvesting some yield, it would make sense to own intermediate-term municipal bond funds, whose managers favor revenue bonds within a broadly diversified framework, including exposure across states and issuers.

Despite the newsworthiness and human cost of Detroit's fiscal catastrophe, Michigan is not one of the largest states within the municipal bond market. In fact, bonds from all of Michigan account for less than 2.6%, or so, of the national total. (The largest issuing states are California and New York.)

While GOs account for a little less than half the municipal market, several municipal bond funds devote much lower percentages to such bonds.

For example, T. Rowe Price Summit Municipal Intermediate (PRSMX) recently devoted about 16% to GOs, while American Century Intermediate-Term Tax Free (TWTIX) devotes about 30%, just a little more than Vanguard Intermediate-Term Tax-Exempt (VWITX).

Though Fidelity Intermediate Municipal Income (FLTMX) devotes more to GOs (about 46%), its performance so far this year has been as good or better than that of most other intermediate-term municipal bond funds.