Time to Upgrade Munis

05/14/2014 9:00 am EST

Focus: FUNDS

John Bonnanzio

, Funds Net Insight

Municipal bond fund yields have been falling this year. The good news, of course, is that because yields move in the opposite direction of their price, their year-to-date returns are actually quite healthy, observes John Bonnanzio, editor of Fidelity Monitor & Insight.

Let's consider Fidelity Municipal Income. With a duration of 7.9 years (see box), it's one of Fidelity's most interest-rate-sensitive muni offerings. (And with $5.4 billion in assets, it's also their biggest muni.)

Against the backdrop of the 10-year Treasury yield falling to 2.66% from just over 3% at the start of the year, Muni Income's shareholders have enjoyed an impressive gain of 5.1%!

That represents a combination of price appreciation and income from the fund's underlying bonds, which are issued by states, cities, agencies, and local municipalities.

Less interest-rate-sensitive munis have also fared comparatively well in this environment. For example, Fidelity Limited-Term Muni (formerly called Short-Intermediate) (FSTFX:US) has a much shorter duration of 2.7 years.

And while its yield has retreated to 0.74%, down from 0.87% four months ago, its 1.3% gain is the same as its taxable counterpart, Limited Term Bond (also up 1.3%).

But here's where things get interesting. Although muni bond yields (and also taxables) have retreated, owing, in part, to the higher taxes imposed by Uncle Sam on higher-earners (especially the 3.8% Medicare surcharge), muni yields typically remain more desirable than taxables.

For example, with similar credit and interest-rate risk, Investment Grade Bond yields 2.43% versus 1.76% for Intermediate Muni.

However, investors in tax brackets of 33% and higher (actually 36.8% with the surcharge factored in—which we've done in the table) will benefit from superior tax-equivalent yields—up to 3.11% for the most highly-taxed.

As you'll see in the box below, we've upgraded our ratings on 17 muni bond funds:

Click to Enlarge

The primary reasons are that the housing crisis has passed, and many government entities have begun the long and arduous task of repairing their balance sheets.

While this has caused a number of statehouse battles to erupt (probably with more coming), regardless of one's politics, aligning spending with tax receipts eventually becomes a mathematical imperative.

In addition, muni investors have grown more comfortable now that Detroit's bankruptcy and subsequent reorganization hasn't resulted in a nationwide credit-contagion. And, even Puerto Rico's recent bond offering has confounded pundits, as it's been embraced by the credit market.

Thematically speaking, we have upgraded Fidelity's five nationally diversified munis (and California Ltd Term) to Buy from OK to Buy. At the same time, eleven other state-specific funds (which are less diversified, and so they're are a bit more risky) are upgraded to OK to Buy from Hold.

A final thought: Whenever the feds are looking for more “revenue,” the idea of munis losing their tax-exempt status is often used as a political bargaining chip.

But state and city officials of all political stripes remain anathema to that idea because bonds are central to how they finance everything. So, if history repeats, such talk often portends a muni buying opportunity.

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