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By Emory Zink and Christine Benz | 02-23-2017 03:00 PM

Munis Rebound From Postelection Sell-Off, but What's Next?

Morningstar's Emory Zink offers three fund picks amid potential policy changes that could affect the municipal bond market.

This video is part of Morningstar's Tax Relief Week special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The municipal bond market came under a cloud in the wake of the election. Joining me to discuss what's been going on in the market and to share some picks is Emory Zink. She is a manager research analyst with Morningstar.

Emory, thank you so much for being here.

Emory Zink: Thank you for having me.

Benz: Let's talk about what went on in 2016 in the wake of the election. We did see a big sell-off in the municipal bond market. What drove munis down during that period?

Zink: Well, I think, something that's important to keep in mind really is that the technicals within the municipal market were actually quite strong in 2016.

Benz: And what does technicals mean?

Zink: So, when we're talking about the technicals, we're sort of talking about the supply and demand. In particular, there were more upgrades than there were downgrades. The default rates were much lower than their corporate counterparts. In terms of supply, because there were such low interest rates, 60% of new issuance was really refinancing. So, there was a lot available. And then in terms of demand, that was also very high. In particular, we've been hearing that there was even interest from international investors, who of course were really attracted to the higher yields and the strengthening dollar. So, when we look at those technicals, in the first three fourths of 2016, municipals actually performed pretty well. It was following the U.S. presidential election in November that the Bloomberg Barclays Municipal Index lost close to 4%, but it since rebounded in December and January.

Benz: So, let's talk about those factors that weighted on the muni market postelection. What were investors concerned about, and why did they want to get out of munis at that time?

Zink: Well, on the campaign trail, the Trump administration, they were really talking about a number of policies that would affect the municipal market, one being tax reform, potentially lowering the corporate tax rate. And then, of course, whenever you discuss tax reform, there's also the option of eliminating that tax exemption which is very important for municipals. There was the discussion of repealing the Affordable Care Act. That would have an effect on a number of the healthcare credits that had benefited from an expansion of that program, as well as privatizing infrastructure spending. So, all of these things that had been discussed but haven't quite materialized created a lot of uncertainty in the markets, and that really fueled that November dip.

Benz: And I guess another issue that affected bonds more broadly after the election was just concern that there could be some spending that could stoke inflation and that would be bad for bonds, right?

Zink: Absolutely.

Benz: OK. So, let's look at questions that munis face in the future. Do you think that these are concerns, this idea of lowering taxes, perhaps making munis less attractive relative to their taxable counterparts, the muni tax exemption going away? How big a factor should that be when investors are looking at munis for their portfolios?

Zink: When we've spoken with a number of municipal managers, one of the things that they've emphasized to us is that these are big policies. So, when we talk about the lowering of the corporate tax rate--so right now it's 35%, they've talked about maybe taking it down to 25% or 15%--that would make municipals a lot less attractive for banks and for insurance companies, which hold about 25% of the municipal market. If that were to happen, the demand for municipals would lower, as well as the fact that during periods of stress they really provide sort of a liquidity backstop for the broader marketplace. So, it would be kind of a big deal. But is that actually going to happen, this is really kind of an important policy change. If it were introduced, it would have to go through Congress, it would have to be approved, and then it would have to be implemented. So, the conclusion that a lot of the municipal portfolio managers have shared with us is that it's too early to know. It's something that they talk about, but it's too early to really factor in just yet.

Benz: One headwind confronting all types of bonds is the prospect of higher interest rates, which we've been talking about for, what, seven years now. But I think investors are a little more concerned right now that rates could go up in a meaningful way, perhaps as soon as over the next year. So, let's talk about that and the effect there for municipal bonds. And let's talk about some of the issuance. I know it tends to be longer, so munis tend to be a little more vulnerable in the fact of interest-rate changes, right?

Zink: Right. Well, just as you mentioned, when we talk about a rise in interest rates, there is no guarantee that's going to happen. We were expecting it in 2015; the Fed delivered at the very end of the year. Same with 2016. So, upfront, I would say, can we actually expect those interest rates to rise? Well, it depends on when the Fed is looking at the numbers, what do they think. But if that's the case and those interest rates were to rise, it would sort of affect the shorter end of the yield curve first and then it sort of comes across the entire yield curve to the longer end. And while the municipal yield curve isn't the same as the Treasury yield curve, they tend to move a little bit together. So, we would expect if interest rates were to rise that those municipals, which tend to be longer duration, of course, would feel more of the pain.

Benz: So, is the answer to stay short or should you just kind of match the bond fund to your expected holding period if you have, say, five years, maybe you're OK with an intermediate-term product? How should you think about that?

Zink: Well, looking at your total portfolio, if you pick something that's intermediate and you're comfortable with that duration, you should stick with it, in particular with municipals. I mean, I can't imagine that you're going to see wide swings. Of course, that's separate from all of this sort of policy issues that are taking place. But on the longer term, a lot of the portfolio managers have already sort of looked at that. They are expecting that, and I don't think you would necessarily need to tweak your portfolio based upon it.

Benz: Let's take a look at some of the picks, the fund picks that you and the team like.

Zink: So, when we're looking at municipal funds, we're always really looking for a robust process and for a lot of experience, deep sources. And so when we're considering the shorter duration options, one that we really like in the municipal space is the Gold-rated Fidelity Limited Term Tax-Exempt Fund. It's a little more conservatively run. They keep it higher quality, an eye on volatility, and it's priced really well. 

If we're moving out to longer duration, we also really like the Gold-rated Fidelity Tax-Free Bond. It's also much more conservatively run, higher quality, keep an eye on volatility as well, and priced very well. 

When you're looking at any of the Vanguard funds, we have Silver-rated Vanguard Long-Term Tax-Exempt, which also provides sort of a conservative constrained approach. But as mentioned, the price tag is hard to beat.

Benz: And do you find that there is a connection with price, with a lower price, and risk-taking? Do you find that sometimes the cheaper funds tend to take fewer risks and they can still be competitive?

Zink: True. Lower price always helps with performance. But in general, in the municipal space, the funds that are going to have that lower price tag are also very aware of delivering value to their investors and sometimes that coincides with having a very robust and thorough process and being conservatively minded.

Benz: OK. Emory, thank you so much for being here to provide a recap of what's been going on with munis.

Zink: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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