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Buying a municipal bond fund [ClearOnMoney]
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Buying a municipal bond fund

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Investment

Buying a municipal bond fund

30 Jan 2011 by Jim Fickett.

There has been something of a rush out of municipal bond funds recently, fed in part by rather shallow reporting on risk. This presents an opportunity. In general the Fed has succeeded in making fixed income investments unattractive but, after the recent drop in values, municipals are worth considering. On Friday I put 2% of the portfolio into FLTMX, Fidelity's intermediate municipal bond fund.

There has been a rush out of municipal bond funds lately. Most probably this started as high issuance and generally rising interest rates caused values to decline, but was fed by many reports on the long-term budget difficulties faced by state and local governments, and widespread speculation of defaults.

There is little doubt that state and local governments face some difficult long-term adjustments, due principally to having (1) ramped up spending too optimistically during the boom years, and (2) made unrealistic promises for both pension and post-retirement health care benefits. But default is another question.

Many of the scariest headlines followed a 60 Minutes segment in which Meredith Whitney predicted at least 50 “sizable defaults” totaling “hundreds of billions of dollars”. The detailed report is not available, but she has several times stated the central thesis, that “States clearly have been funding municipal governments—for now up to 40 percent of their total expenditures. As the states become more compromised from a fiscal standpoint, that funding is going to end.” The funding won't end, of course, but it may well be reduced, so qualitatively, at least, this makes sense. (One can also add to this that some municipalities will probably end up taking on the debt of failed independent authorities.)

Whitney has a mixed record. Her analysis of banks in the early stages of the crisis was prescient. However, as the recession was ending she stated that a pullback in consumer credit would cause a drop in consumer spending, and recommended shorting consumer discretionary. It made sense, but failed to pan out.

On the other side, many of those who currently argue that municipal bonds are safe make remarkably weak arguments. Robin Prunty, Team Leader for State Ratings for S&P, basically says 'trust us': “We feel based on current criteria our outlooks and where our credit outlooks are we are comfortable with the sector.” Perhaps Mr. Prunty failed to notice S&P's performance on CDOs. Boston College points out, in an Oct 2010 study, that, in aggregate, the unfunded pension problem is manageable. However the problems are distributed very unevenly, and the aggregate situation does not tell one very much about the likelihood of defaults. (And note that although S&P has started to take pension liabilities into account, they have not got as far as retirement health care liabilities.) Bond Girl, at Self Evident, does point out some mistakes in Whitney's statements, suggesting her lack of experience in this area makes her prediction less credible. She also points to a study showing that “the 100 largest county and city issuers do not in aggregate have $100 billion in debt outstanding”, which certainly makes it seem less likely that Whitney could be right.

Despite the general weakness of the arguments for safety, I think widespread defaults are unlikely:

  • The biggest problem widely cited, retirement benefits, is a very long-term one; this is not going to cause large numbers of defaults in the next few years
  • The experience of Vallejo has not been very positive, increasing the likelihood that most municipalities will do their best to avoid bankruptcy
  • Whereas many people were making persuasive arguments in 2007 that subprime mortgages were likely to result in defaults in the hundreds of billions, there is no one making any public, persuasive argument, with data, that many municipal defaults are coming

In addition, if you know enough to choose bonds well yourself, or if you choose a conservative fund with skilled management, the odds of default can be reduced significantly. So I think the recent rush out of munis, and the subsequent drop in price, represents an opportunity. I looked at several funds. I didn't like the sales charge on Pimco's fund, and there were too many independent authority issues for my taste in Vanguard's. I settled on Fidelity's intermediate muni fund, FLTMX, with an average duration of 5.4 years, which is paying 3.1% and is down 5.1% from the recent peak. The comparable taxable fund, FTHRX, has a duration of 4 years, is paying 2.7%, and is down 2.7% from the peak. It also gives me some comfort that the price of FLTMX is back down to near its long-term average.

At a duration of about 5.8 years, a rate rise of 0.35 percentage points costs you about 2.0 percentage points in value. For a fund paying 3.3%, with inflation at 0.8%, the return under those conditions would be 0.5%. (Of course, that is a middle-of-the-road estimate of where rates might be going. If you buy bonds in any form right now you should be prepared for some volatility.)

For another, similar take on the whole situation, and an independent endorsement of FLTMX, see Stan Luxenberg, writing at The Street.