(10/18/11) What Happened to the Muni Meltdown?

So far there have not been the massive defaults in the muni bond market that some predicted, says Morningstar’s Russel Kinnel, and he thinks their future prospects are fairly bright. He explains his favorite way to play them in this exclusive interview with MoneyShow.com.

A while ago, there were thoughts that the municipal bond market was just going to implode, that we were going to see defaults left and right. Is that happening or what happened?

Well, it didn’t happen, fortunately. There were some really scary predictions about massive muni defaults, but in fact we’re actually seeing fewer defaults this year than in years past. We’re running at, I think it’s about $100 million so far this year and it’s really a pretty modest level.

So munis are under a lot of strain, but we aren’t seeing massive defaults. And really not many people actually expected that, at least the muni experts that I’ve talked with.

Well, what’s the outlook for municipal bonds now, particularly in light of the fact that government spending is going to be cut, and state and local governments will not be receiving that type of federal aid? What’s going to happen there?

That’s right. Well, we’re not seeing defaults, but I don’t want to make it sound like things are rosy. Munis are definitely under strain.
Cities and states are really having to cut.

They’re having a hard time making a go of it, but that doesn’t mean they will default. Cities and states have the unique ability to tax and they can cut spending, and they’re doing that. We’re seeing that they’re able to do that.

But it is also important to know that munis are very dependent on further issuance. It’s not just that they sold a few bonds a few years ago and that’s it. They need to keep coming to the markets. If they default, the markets are going to shut the doors on them.

So, they have a lot of incentive to keep making payments. And so, I think the prospects are actually fairly bright.

Let’s talk a little bit more about the types of municipal bonds. I know there are general obligation bonds, revenue bonds, tax anticipation bonds...Is there a particular sector that should do better than others?

You know, I think there may be. But I look at it from a fund perspective, so what I do is I hire someone to make that decision for me.

I think Fidelity is maybe the best muni manager out there. So, that’s what I do. I hire someone like Fidelity and the good muni funds. Not only do they have low costs and good management, but they also offer tremendous diversification both by issuer and by sector, so that if one sector is under stress, they’re not going to get hit too hard.

That’s one of the big advantages over owning munis yourself, is that you can get hundreds of issues in a muni fund, and that really smoothes the ride out for you.

Do you have some suggestions for investors to take a look at?

Yes, I think Vanguard and Fidelity run the best muni funds out there. If you’re in a high-tax state and there is a muni fund dedicated to your state from Vanguard or Fidelity, that’s where I’d start first. That’s probably the best way to go.

They’re both low cost, well-run funds. I think Fidelity has a little bit better management, but Vanguard has a little lower cost, so they’re kind of an equal, good trade-off.

And, you’re saying you should look at them if you’re in a high-tax state because municipal bonds, of course, get some sort of beneficial tax treatment?

That’s right. Muni bonds, the income from them is exempt from taxes. Therefore, when you look at that yield, you have to appreciate that that is a tax-free yield, so it’s really better than say an equivalent Treasury bond or other corporate bond that’s going to be taxable.

Any Fidelity fund that you’re looking at right now?

On a national front, I like Fidelity Tax-Free Bond (FTABX), just a great straightforward national muni fund.

And how about for Vanguard?

I like really an array of Vanguard funds. I wouldn’t name any particular one. I think they’re all pretty similar. I think long-term munis are worth looking at despite the fact that people are a little worried about interest rates, but I really think it depends on what state you want to invest in.