(PUB) Morningstar FundInvestor

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Munis and TIPS Beckon Income Strategist | Michelle Canavan Ward

exposure. While there may be additional future vola- tility in the market and munis do have interest-rate sensitivity, there are several funds that may be a good fit for those with a long time horizon. The team from Fidelity, led by veteran Mark Sommer, offers a straightforward and careful approach to the muni markets via Gold-rated Fidelity Municipal Income FHIGX and Fidelity Tax-Free Bond FTABX . These funds eschew leveraged structures and tread care- fully in the muni market’s diciest names, which has given investors a relatively smooth ride and solid returns. Vanguard also provides relatively conserva- tive exposure to the muni market at rock-bottom prices through its family of tax-free funds, including Silver-rated Vanguard Intermediate-Term Tax- Exempt VWITX and Vanguard Long-Term Tax- Exempt VWLTX . Even when after-inflation (real) yields on Treasury Inflation-Protected Securities turned negative in recent years, many managers still argued that expec- tations for the eventual onset of inflation justified keeping money in the category, particularly over comparable Treasury bonds. As of Dec. 31 , 2013 , the backup in rates meant that after-inflation yields across the curve landed in positive territory, while inflation-expectations—derived from pricing differ- ences between TIPS and conventional Treasuries— remained below the historical average. For example, pricing differences at year-end implied an expected rate of inflation of 1 . 7% during the next five years. If one believes that inflation will be higher than 1 . 7% annualized during the next five years, now may be a good opportunity to invest in an inflation-protected bond fund. TIPS offer an explicit link to inflation and can play an important role in a diversified port- folio. Proven funds worth considering here are Gold-rated Harbor Real Return HARRX and PIMCO Real Return PRRDX , both of which are managed by PIMCO ’s head of real-return portfolio management Mihir Worah. For cheaper and more benchmarklike exposure, Vanguard Inflation-Protected Securities VIPSX is another solid option. œ Contact Michelle Ward at michelle.ward@morningstar.com

As most equity markets surged to record highs in 2013 , the summer sun burned the bond market. The prospect of the Fed tapering its purchase of bonds sooner than expected rattled the market in May, and many fixed-income sectors took it on the chin during the summer months and haven’t fully recovered. Among the worst-performing areas of the market were inflation-protected and municipal-bond funds, as other factors specific to those sectors further exac- erbated the losses from the broader sell-off. Given that backdrop, and drawing on inspiration from Russ Kinnel’s annual “Buy the Unloved” approach to the equity markets, there’s a case to be made for a buying opportunity in those areas. Both categories experi- enced significant outflows in 2013 , to the tune of $ 29 billion out of inflation-protected bond funds ( 25% of category assets) and $ 58 billion out of the overall municipal-bond fund universe ( 10% ). Indeed, investors hitting the exits in droves were themselves a contrib- uting factor to the categories’ weak performances, as fire sales in the midst of the sell-off put additional downward pressure on prices in those two relatively illiquid markets. That was particularly true of muni-bond funds, where mutual funds are big players in the market and the selling pressure significantly affected pricing. What’s more, the Detroit bankruptcy filing and turmoil in the Puerto Rican debt markets weighed on returns and caused additional bouts of volatility. Funds in the muni-national long and high-yield muni categories were hit the hardest, but all U.S. municipal fixed- income categories lost money in 2013 . Sell-offs often create opportunities, though, and as of late, municipal bonds have looked very cheap relative to Treasuries on a historical basis. See the chart on the facing page.

Factoring in the tax benefits of owning munis, mean- while, may make this an opportune time to add