Lyle Fitterer sounds like a true believer when describing the attractiveness of municipal bonds versus other sectors of the fixed-income universe. “The municipal market is by far the most attractive asset class in the fixed-income space right now,” says the 47-year-old manager of the Wells Fargo Advantage Municipal Bond Fund. “They look better than Treasurys, emerging market debt, corporate bonds and just about any other sector of the bond market right now.”

A similar assessment comes from Wells Fargo chief fixed-income strategist James Kochan, who noted in a commentary issued earlier this year, “It would be difficult to overemphasize the attractiveness of municipals today,” he says. “By virtually any metric, the municipal market is exceptionally cheap relative to the taxable markets.”

Fitterer’s and Kochan’s assessments are based on a number of factors:

• High yields relative to Treasury securities. A 10-year “AAA”-rated municipal bond yields between 90% and 95% as much as a 10-year Treasury security. Historically, the average yield difference is around 80%. The yield on a highly rated 30-year municipal bond is 107% that of a 30-year Treasury bond, compared to a historical average of about 90%. With tax-adjusted yields above 5% for investment-grade issues, municipal yields compare favorably with high-yield and emerging market debt.

• Higher taxes. With the increase in the top marginal tax rate and added taxes from the Affordable Care Act (ACA), the top federal tax rate for the country’s highest earners is over 42%, making the tax exemption especially attractive to that group.

• Investors are getting an attractive risk premium. The yield difference between bonds rated “BBB” (excluding Puerto Rico) and those with a rating of “AAA” is between 225 basis points and 240 basis points, about twice as high as the historical average spread between the two credit tiers. By contrast, the spread between similarly rated corporate securities is only around 80 basis points, compared to a long-term average of 115 basis points.

These observations come after a tough 2013 for the municipal bond market marked by several events, including Detroit’s bankruptcy filing and Puerto Rico’s high-profile budget woes. Those credit-related issues came on top of a selloff in the Treasury market during the summer after the Federal Reserve proposed tapering off asset purchases that have helped keep interest rates in check.

As a result, the municipal market took a harder hit than other corners of the fixed-income universe. In 2013, the fund ended the year with a loss of 1.97%, and the Barclays Municipal Bond Index was down 2.55%. The index’s loss was the muni market’s worst in nearly two decades, and provided stark contrast with a 6.78% return in 2012 and a 10.7% return in 2011.

Fitterer observes that a few bad apples threw a wrench into the entire municipal market last year, and observes that the group seems more susceptible to “contagion” from bad news among individual issuers than other sectors of the bond market. “When Enron filed for bankruptcy, no one assumed that IBM would do the same,” he says.

Nonetheless, investors reacted to high-profile credit problems by pulling money out of muni funds, forcing some investment managers to sell bonds into a bad market to meet redemptions. Fitterer wasn’t one of them, though. Concerned about unattractive valuations in the municipal bond market, as well as the threat of rising rates, he had sold positions earlier in the year and raised cash to nearly 20% of assets by June. As the market got battered, he began buying, and today the fund’s cash level is back to about 6%.

The muni market rebounded in early 2014, with the fund posting a nearly 3% return in January. Fitterer believes the strong launch from the starting gate is more than a post-beating bounce-back. For one thing, he believes the market has already priced in the bad news out of Detroit and Puerto Rico, both of which have a minimal presence in the fund. “Will we see further credit events? Yes. Will we see another Detroit? Not necessarily. While further events in Puerto Rico might have an impact on the market, I think it will be less than many people anticipate.”

Despite these well-publicized debacles, municipal finances are getting stronger and stronger every year, and the widespread municipal bond market defaults predicted by analyst Meredith Whitney in 2010 have thus far failed to materialize. “In many states, we are seeing higher tax receipts, and even budget surpluses. From a financial perspective, some municipal credits look better than U.S. Treasurys.”

Going Out On The Yield Curve
Fitterer believes that municipal bonds at the longer end of the yield curve offer a better value now than those maturing in three to five years, which are seeing high demand from investors who want higher yields than they can get from money market funds but who are also concerned about interest rate risk associated with longer-term investments. As a result, high-quality municipals in the three-to-five-year maturity range offer about 68% of the yield on comparable Treasury securities, which is about the historic average.

But today’s muni yield curve is unusually steep, which means the yield difference between longer-dated bonds and shorter-term ones is much wider than it usually is. “A 10-year muni bond yields about 2.75%, versus a yield of 0.35% for a two-year bond,” says Fitterer. “That extra 2.4% yield is a substantial incentive to go out further on the yield curve, and it provides a nice buffer against any modest increase in rates.”

With that in mind, recent buying has been focused in the 10- to 25-year maturity range. The fund is taking a “barbell” approach by pairing those bonds with short-term securities to create an 8.57-year overall duration, about the same as the Barclays Municipal Bond Index. Fitterer says he’s unlikely to extend duration much further, although he “wouldn’t be surprised” to see yields increase modestly through 2015.

In addition to adjusting maturities and portfolio duration, Fitterer looks for credit-related blips and pricing inefficiencies that have become increasingly common in the municipal market. Such opportunities were less common a few years ago, when insured bonds, which automatically received a rating of “AAA,” regardless of the issuer’s creditworthiness, were a dominant force. Today, after the demise or downgrade of those insurers following the financial crisis, only 12% to 15% of municipal bonds carry the highest rating. “The municipal market is now a credit market, so we have more volatility related to credit events,” he says.

Because Fitterer believes that medium- and lower-quality bonds offer the best values, recent purchases have focused on issuers whose credit ratings sit below the top tiers. “We’re continuing to find value in the ‘A’-rated, ‘BBB’-rated and high-yield categories because their spreads remained attractive and we believe the yield levels compensate investors for the credit risk,” he says.

A number of bargains in that category that he picked up during the municipal bond downturn last year have increased in value over the last several months. They include an issue from the California Pollution Control Financing Authority to fund Poseidon Resources in San Diego. The bond deal was done to finance a desalination plant and pipeline, one of just a handful of such projects in the world. The fund purchased the bonds in September 2013, when they were yielding 6.7% and sold at a price of $77, a discount of 24% off the new issue price just nine months earlier. Demand from high-yield funds, as well as a California drought that has increased awareness of the need for such facilities, has lifted the market for the “Baa”-rated securities.

After Illinois and Chicago general obligation bonds received a ratings downgrade in June 2013, largely because of huge pension liabilities, many bonds issued in the state lost value and yields became more generous. Fitterer decided to take advantage of the downturn to buy “A+” rated Chicago Board of Education school funding bonds in September 2013. At the time, they were offering a yield of 6.52%, some 282 basis points more than “AAA”-rated bonds. After state pension reform was passed in December, bond prices improved and Fitterer took profits on part of the position. “The state of Illinois proved its willingness to tackle its fiscal problems and the bonds are back in demand,” he says.

The fund also owns a number of bonds issued by municipal utilities to fund contracts that lock in low gas prices, including those issued by Texas Municipal Gas Acquisition Corp. Since the proceeds are used to finance long-term gas delivery contracts from Bank of America/Merrill Lynch, the rating of the bond moves with the rating of that firm. Yet the tax-exempt bonds have a tax-adjusted yield of 6.73% (assuming the federal tax rate is 40%), nearly 2.75 percentage points higher than the yield of a taxable Bank of America 10-year bond.