(PUB) Investing 2015

20

The Road Gets Bumpier for Long-Term Muni Funds Income Strategist | Sarah Bush

billion in net outflows for the year. As a result, many investors didn’t benefit from the sector’s impressive rebound in 2014 . There are signs, however, that 2013 ’s lessons haven’t been so quickly forgotten. Overall flows to funds across the municipal-bond categories recovered nicely in 2014 , but the muni long-term cate- gory continued to suffer outflows into 2014 . While the category is unlikely to repeat its 2014 returns, there’s nothing to suggest that munis are headed toward a meltdown. True, headline risk hasn’t completely faded away: Puerto Rico’s fortunes remain unclear, and Illinois’ new governor will have to quickly address the state’s looming budget deficit and pension obligations. However, most munici- palities have seen improvements in their finances in recent years. Tax revenues are up, and defaults hit a three-year low in late 2014 . Meanwhile, muni bonds look more attractive when compared with Treasury bonds. As Treasury yields rallied hard in December and January, muni yields lagged modestly, leaving the ratio of muni to Treasury yields—a much-watched measure of the relative attractiveness of the two markets—in attractive territory as of late February. For those considering an investment in the category, several Morningstar-rated options look particularly attractive. Fidelity Municipal Income FHIGX , with a Morningstar Analyst Rating of Gold, benefits from an experienced team, deep analytics, and an attractive price tag, while steering clear of big interest-rate bets and treading carefully in lower- rated fare. Vanguard Long-Term Tax Exempt VWLTX blends super-low expenses with a straightfor- ward approach to the market, while Franklin Federal Tax-Free Income ’s FKTIX buy-and-hold strategy and generally high-quality portfolio has an impressive record. œ Contact Sarah Bush at sarah.bush@morningstar.com

Like their taxable-bond counterparts, munis have been on a tear since the beginning of 2014 . The sector benefited from the impressive rally in broad bond market yields, led by the Treasury market, and also from favorable supply/demand dynamics in place for much of the year. After suffering $57 billion of outflows in 2013 , funds in the various municipal- bond Morningstar Categories saw an estimated $29 billion in net inflows in 2014 . Returns for long- term municipal bonds were especially strong. The muni national long-term category gained 12 . 5% on average from the beginning of 2014 through January 2015 . While such a gain is eye-catching, especially for a category focused on investment-grade bonds, the potential for returns is less rosy going forward. That’s due to simple math. On the heels of last year’s rally, the yield on the Bond Buyer GO was 3 . 6% as of late February 2014 , down from 4 . 7% in late 2013 . Even though the yield looks a bit better on a tax- adjusted basis, that’s still meager by historical stan- dards. Meanwhile, SEC yields on long-term muni funds, which also often invest in short- and interme- diate-term debt, look decidedly sparse at just 1 . 7% . Yields are important because, while bond prices can fluctuate from year to year with changes in interest rates, a bond’s long-term return ultimately comes from its yield, making yields a good indicator of future total return potential. Investors considering an investment in muni bonds after 2014 ’s rally should also be taking the long- term muni category’s significant interest-rate risk into consideration. Like their long-term taxable counter- parts, the prices on long-term muni bonds are vul- nerable to big losses when bond yields rise. During the worst of 2013 ’s muni sell-off, funds in the muni long-term category lost 8% on average just between May and August, helping to feed an estimated $13