For many people, putting the description "boring" in front of "municipal bonds" is repetitive. But disagreeing is one of the country's most influential fixed-income managers, who is enthusiastic about a municipal bond market that she says is more exciting than any she has seen in her 23-year career.
"This market is more than interesting. It's unprecedented," says 49-year-old Christine Thompson, who oversees six tax-exempt funds and $20 billion in assets for Fidelity. "Values relative to other asset classes are at levels we have never seen. It's a great opportunity to enter the municipal market and to benefit from attractive relative returns as market conditions stabilize."
Across the maturity spectrum, municipal bond yields are equaling, and often exceeding, the yields on taxable securities. Driven by credit problems and technical pressures, two-year triple-A municipal securities yields stood at an unheard of 180% of comparable Treasury securities in early March. Longer-term bonds with maturities in the 20- to 30-year range, which rarely match the yields of comparable Treasuries, were yielding 20% more. Among Fidelity's stable of funds, the recent 5.98% taxable equivalent yield of Fidelity Municipal Income Fund for someone in the highest federal tax bracket beat the 4.87% taxable yield of the Fidelity Investment Grade Bond Fund and the 5.78% yield of the Fidelity Strategic Income Fund, which contains a significant below-investment-grade and emerging-market component.
High relative yields aside, a series of hedge fund and bond insurer-related issues are still clouding the market, and municipal indexes have lagged most taxable bond indexes by a considerable margin over the last year. But with so much value out there, Thompson believes that underperformance relative to taxable securities should reverse, and that tax-exempt securities "are poised to outperform taxable fixed-income by a wide margin" over the next year.
What has driven muni prices down, and their yields up, is a confluence of events behind a flood of selling and a crisis of confidence among investors. Late last year and early this year, hedge funds such as 1861 Capital Management, Duration Capital Management, Blue River Asset Management and others began selling their municipal holdings as munis cheapened in comparison with Treasuries and their hedges unraveled. Although retail investors historically have favored municipal bonds, hedge funds and foreign investors have become more active participants in recent years.
As the hedge funds flooded the market, bond-rating agencies put several bond insurers with excessive subprime mortgage exposure on credit "watch lists," a harbinger that their triple-A ratings-the same treasured rating status conferred on the bonds they insure-are teetering dangerously close to a downgrade. Because these insurers have backed about half of all bonds sold in recent years, the impact reverberated in virtually every corner of the muni market. As investors began trading the bonds based on their underlying credit ratings rather than their insurance carrier's financial strength, prices on many insured bonds fell in value and yields rose.
Although Thompson believes municipals have been driven down to very attractive valuations relative to taxables, her short-term outlook remains guarded. "You can't say the problems with the bond insurers are over unless you can predict what the housing market will do. The initial shock is over, but several insurers remain on negative credit watch. Technical pressures will work out, but it may take some time. The problems in the market have not yet been played out."
The strength of state and local governments also comes into focus as states such as California struggle with the uncertainty of falling housing prices and growing budget deficits. According to the Center on Budget & Policy Priorities, 50% of states are facing budget deficits and revenue shortfalls. Although defaults on general obligation bonds are extremely rare, a credit downgrade could affect the value of bonds backed by softening tax revenues. In light of economic uncertainty Thompson is drawn to water and sewer bonds, whose debt is paid from private receipts for an essential service rather than more cyclical tax revenues. Higher education bonds also get the nod because of demographic trends that point to increasing enrollments, as do bonds of states such as Illinois and Texas that have no or low state income taxes. The latter bonds generally offer better values than bonds from states where high state income taxes lead to strong in-state demand and higher valuations for bonds issued there.
As technical and credit factors continue to permeate the market, the economic environment remains vulnerable. "We are in a cascading credit contraction that may be difficult to remedy and I am concerned about the financial industry's ability to deal with credit issues, and the Fed only controls one key interest rate so there are limits on what it can do," she says.
Thompson believes that although many financial advisors buy individual bonds, today's complex market makes a low-cost mutual fund a better alternative for most of them. "A bond is a contract with about 500 pages of documentation behind it. Even if it is insured, recent events illustrate that you need to know something about the underlying issuer, and most people do not have the time nor expertise to really evaluate all that."
For 44 basis points a year-significantly less than the 109 basis points charged by the average municipal bond fund-shareholders get a relative bargain and broad market exposure in the Fidelity Municipal Income Fund. "Such low expenses are what we'd expect in an index fund, but investors buying in here actually get access to an actively managed portfolio from one of the best muni teams in the business," notes Morningstar analyst Andrew Gunter in a recent report. "All things considered ... especially the depth of its investment team and its low expenses-we think this fund's future is as bright as its past."