Six Reasons to Consider Munis

08/18/2015 9:00 am EST

Focus: MARKETS

John Bonnanzio

, Funds Net Insight

Like all bond funds, Fidelity’s 17 tax-free municipal offerings face several headwinds, suggests John Bonnanzio, fund expert and editor of Fidelity Monitor & Insight.

First, there is the prospect of rising interest rates. Second, there is a lack of demand by retail investors. Third, there is growing supply by higher-quality issuers (including towns, cities, states, and other bonding authorities).

And finally there is risk of default contagion owing to perceived problems in Puerto Rico and especially Chicago.

Because of these factors—coupled with last year’s strong, equity-like returns—munis are merely treading water this year. By comparison, Fidelity’s two biggest offerings gained about 11% apiece.

So, are the past seven months prologue for munis or are there reasons to believe that today’s headwinds will shift into tailwinds?

We’ll begin by noting that all five nationally diversified munis (plus California Limited Term TaxFree) are rated Buy, whereas 11 state-specific munis are OK to Buy. More geographically concentrated funds are riskier.

More highly taxed investors should consider muni funds. We prefer the less risky, nationally diversified variety. The chart below shows the tax-equivalent yields of Fidelity’s 16 muni bond funds:

chart
Click to Enlarge

Here are the reasons we like munis with today’s headwinds:

1. Given today’s higher tax rates (including the 3.8% ACA surcharge levied on the nation’s highest earners), muni funds’ tax-equivalent yields surpass comparable taxables;

2. We don’t know of many investors who will be truly surprised by the Fed’s first rate-hikes, so it’s possible that their initial move higher will be greeted by a big yawn.

Moreover, we believe that the pace of future hikes will be muted as slow global growth keeps inflation in check;

3. Unlike any other asset class, munis are predominately owned by individuals, while specific issues can be less liquid.

This can make munis more volatile. However, muni investors tend to buy and hold, helping to make them less volatile during periods of stress, especially relative to corporates;

4. The current unfavorable supply/demand imbalance is showing signs of improvement. Despite healthier balance sheets, muni issuers are cautious (even in California) and will remain that way until tax receipts and other important economic metrics substantially improve.

As for demand, once investors lose their fear of the Fed and inflation (which is running well below the Fed’s target of 2%), their appetite for munis should pick up;

5. In our view, debt contagion is overblown;

6. Muni funds remain good portfolio diversifiers as they are a distinct asset class. Bottom line: Despite headwinds, muni funds still make sense for tax-sensitive, income-oriented investors.

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