Loughran, like other municipal bond portfolio managers, favors state tax-backed bonds and essential services bonds, particularly in the Southwest and Southeastern states where budget problems are less serious. "These problems in the municipal bond market are for taxpayers, not bond investors," he says. "We take a bottoms-up approach to investing. We favor long maturity bonds in the new and secondary markets that represent the best values in terms of yield and credit rating. Over the long term, these bonds offer the highest yield and total returns for income investors."
Loughran says there will continue to be a lot of volatility. States are attempting to cut budgets, increase taxes and gradually reduce unfunded pension liabilities. They are taking steps to improve their financial conditions and avoid defaults.
"It takes a crisis before they cut expenses and raise taxes," he says. "It's not a popular thing to do. Improvements in public finances tend to lag what happens in the economy. But this is the third quarter in a row where state tax revenue has increased. Last month [October 2010], tax revenue increased 6%."
Loughran stresses that financial advisors should focus on how much clients are willing to see their municipal bond values drop over the short term. Concerned investors should stick with higher-grade shorter-term bonds because they are less volatile.
Philip Condon, head of the municipal bond portfolio of DWS Investments, says that despite the volatility, municipal bonds should still be considered a core allocation for fixed-income portfolios. "Despite some changes in the market's volatility and valuations, which can seem very ominous while they are taking place, the fundamentals have not changed," he says. "We have to remind ourselves to maintain perspective."
Condon favors revenue bonds over general obligation issues. The DWS Intermediate Tax/AMT Free Fund, has 60% of its holdings in investment-grade-rated revenue bonds. General obligation issues make up 24% of the portfolio. Pre-refunded bonds, which are bonds backed by U.S. Treasurys, make up 5% of the portfolio. He has 20% of assets invested in Texas. Plus, he has 14% of holdings in California general obligations, which he says are performing better.
"The fund's position in California general obligation bonds, backed by the full faith and credit and tax power of the state, performed well [in the third quarter]," he says. "The fund has been adding exposure to 'A'-rated airport issues and health-care-related bonds in the 'AA' to 'A' range."
Financial advisors are concerned. Barry Mendelson, a Walnut Creek, Calif.-based financial planner, would rather stick with Vanguard's municipal bond funds and two iShares exchange-traded funds, the iShares S&P National AMT-Free Municipal Bond fund (MUB) and the iShares S&P Short-term National AMT-Free Municipal Bond Fund (SUB).
"The fundamentals and creditworthiness of municipal and tax-exempt bonds is all over the map," he says. "That is why expert credit analysis is required when buying individual issues. Therefore, due diligence and credit analysis has never been more important."