Muni Funds Remain Promising Picks

12/15/2015 9:00 am EST

Focus: FINANCIALS

John Bonnanzio

, Funds Net Insight

All things considered, it’s been better to own a municipal fund this year than either a corporate or a Treasury fund, explains fund expert John Bonnanzio, editor of Fidelity Monitor & Insight.

While their absolute returns haven’t been great, they’ve generally provided returns that are in line with their year-ago yields.

In other words, muni funds have paid their coupons, but there was little capital appreciation or deprecation.

The same cannot be said of taxable bond funds. Fort example, the Spartan US Bond Index reported a 30-day yield of 2.08% as of December 31, 2014. But its year-to-date return is just 0.8%.

But here’s the kicker for muni funds: their income can be free of federal and state income taxes (though the AMT may apply). On that basis, munis have been a better bet than of taxable bond funds and we think that will be the case again in 2016.

First, let’s discuss the risks. If the recent past is prologue, Detroit’s and Puerto Rico’s failures caused a fair amount unease...but it was fleeting.

Now there are concerns over Chicago and Illinois, but steps to protect against default will likely be addressed by hiking fees and taxes.

We won’t argue the merits of this approach versus, say, spending cuts. But the salient point is this: when towns, counties, agencies, and states run into trouble, they merely squeeze the citizenry a little more. Problem gone.

While that may not sit well with toll payers and taxpayers, the ease by which government entities can do this make muni bond funds manifestly safer than their corporate counterparts (though not as safe as Treasuries).

As for interest-rate-risk, we’re not losing much sleep. Yes, the Fed will end its six-year long policy of keeping short-term rates near zero.

But we certainly don’t expect them to hike at every meeting. The overall health of the US economy will obviously drive those decisions.

Apart from limited rate-risk, muni investors may have to weather the quadrennial rite of politicians calling for the elimination of muni bonds’ tax-free income.

While this always spooks investors, mayors and others always come to munis’ defense, as even they understand that muni bonds are their community’s lifeblood to infrastructure improvements and, well, votes.

They wouldn’t want to slay this golden goose. Another potential positive for the year ahead: the supply of new issuance will be met with strong demand.

So, what should you own? First, here’s what we’d avoid: Fidelity Conservative Income Municipal Bond (FCRDX). For our money, the short end of the yield is especially vulnerable to rising rates, so the risk-reward isn’t attractive.

If there’s a sweet spot for munis for the foreseeable future, it will remain in the middle of the yield chart.

This means a buy rating for the nationally diversified Fidelity Limited Term Municipal Income Fund (FSTFX) and its more rate-sensitive (higher duration) cousin Fidelity Intermediate Municipal Income (FLTMX).

This is where things get tricky. Longer duration munis have us a bit nervous, simply because they’re so interest-rate-sensitive. But their tax-equivalent yields are—relative to taxables—attractive.

And, for the most highly taxed investor, Fidelity California Municipal Income (FCTFX) delivers a tax-equivalent yield of over 3.5%. (That’s based on marginal combined tax rate of 46% for top earners in that state.)

At the same time, the geographically diversified Fidelity Tax-Free Bond (FTABX) gets you 3.89%. To get close to that with a taxable fund you’d have to own Corporate Bond.  While the funds’ durations are similar, Corporate Bond has more credit risk.

All things being equal, munis remain the better bet for higher income investors as they historically outperform other types of bonds in a rising rate environment.

This doesn’t mean they’ll return what they did in 2014 or even 2015. But they remain an essential and promising way for income-oriented investors to invest.

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More from MoneyShow.com:

Summit Muni: Solid Choice for Income

Vanguard Tax-Exempt: Yield and Stability

NEARX: For Your Safe Money

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