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Munis might still make sense

The municipal bond market could be among the better performing asset classes.

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At this juncture in the municipal bond market, investors appear to be of two minds. Some argue that the low interest rate environment and increasing bond valuations indicate it is time to scale back allocations, not just to municipals, but to all fixed income sectors. Others believe that fixed income, and municipals in particular, continue to warrant a core position in investor portfolios.

While we recognize the potential for rising interest rates in the long term, and certain municipal market headwinds, such as looming pension issues, high-profile credit events, and further tax reform, there are also tailwinds that are generally supportive of the muni market. Among them: higher tax rates, slow economic growth, improving credit fundamentals, and limited supply.

Properly managed municipal bond portfolios may provide attractive risk-adjusted returns relative to other asset classes. We believe municipal bonds continue to make sense for many tax-sensitive investors, even among a number of challenging scenarios.

Why investors are concerned about the municipal market

Low yield environment
At current yield levels, investors are thinking about the potential for a shift in the Federal Reserve’s (Fed’s) monetary policy if the economy signals higher employment growth or rising inflation. While moves toward a stricter monetary policy would likely take time, bond investors need to be mindful of the potential for a rise in yields and the detrimental impact such a rise could have on their bond investments. Against this interest rate backdrop, municipal-bond investor unease has been exacerbated by market specific headwinds, such as the growing pension liabilities of municipal bond issuers.

Unfunded pensions
A wave of retiring baby boomers is depleting pension system resources, while the 2008 market crisis and low interest rate environment have hindered pension asset growth. Growing, unmanageable pension liabilities have factored prominently in a variety of recent municipal bond credit crises—downgrades and rising debt costs in Puerto Rico and Illinois; state interventions in Harrisburg, PA, and Detroit, MI; and bankruptcies of Jefferson County, AL, Central Falls, RI, and Vallejo, San Bernardino, and Stockton in California.

We are closely monitoring the treatment of outstanding debt obligations and pension liabilities in municipal bankruptcy cases. The outcomes will likely have implications for the municipal bond market in general and certain states in particular. To date, judgments have not set a consistent precedent.

For example, bondholders experienced a favorable outcome in Rhode Island, where the city of Central Falls declared bankruptcy. There, the state legislature passed a bill that gave bondholders a lien on property taxes to support the general obligation bonds of Rhode Island localities.1

In comparison, outcomes are still uncertain in two California cases, where the results could be less bondholder friendly. Central to the dispute is whether municipal pension obligations are senior to the claims of bondholders. While such a determination would not necessarily apply to all local governments across the country, it could have a chilling effect on the market. Pension issues could lead to headlines and more downgrades, but most are likely to impact valuations of only a handful of bonds.

High-profile credit downgrades
Although California cities have experienced bankruptcies, the amount of debt affected has been small relative to the overall municipal bond market. In contrast, Puerto Rico is a source of more than $60 billion in municipal issuance currently outstanding.2 Much of this debt is currently rated borderline noninvestment-grade. Due to a persistently weak economy, sizable underfunded pension liabilities, and a large budget deficit, municipal bond analysts are closely monitoring developments in the commonwealth.

A downgrade of Puerto Rico to non-investment-grade could have meaningful implications for the municipal bond market. Fund managers, plan sponsors, and other fiduciaries whose guidelines restrict them to holding only investment-grade issues could be forced to sell, hurting valuations of Puerto Rico bonds. Given the large amount of this debt in the market, such an outcome has the potential to have a far-reaching impact on market psyche and liquidity.

Further tax reform
Another issue giving investors pause is tax reform. A limitation on the tax exemption of municipal bonds is still being debated in Washington.

Tax policy uncertainty has the potential to be disruptive to the municipal market. While some limitation has been proposed, we do not believe the federal government is likely to remove the municipal tax-exemption entirely. Though the search for higher revenues might lead Congress to agree on a partial limitation, it would raise financing costs for municipalities as they make inroads to economic recovery, and the move could alienate local leaders.

In addition, such a tax change would not be popular among constituents holding municipal bonds. Given that the federal deficit would be only marginally reduced by such reform, it is unlikely to be a primary agenda item, but could be part of a larger tax reform package.

While we recognize that the preceding factors may be contributing to apprehension among municipal bond investors, a balanced appraisal of the asset class must also factor in the favorable characteristics of the sector.

Supportive municipal market factors to consider

We believe higher tax rates, the slow pace of U.S. economic growth, improving core credit fundamentals, and healthy market supply and demand dynamics should lend support to the municipal bond asset class.

Higher tax rates
Recent tax reforms—the top income-tax rate’s increase to 39.6% from 35%, a higher dividend tax of 20%, and a new 3.8% Medicare tax on unearned income—have made municipals more attractive to many investors (see chart right).

Slow and steady economic growth
The current U.S. economic growth trend—neither too fast nor too slow—would be good for the entire U.S. bond market, especially municipals.

A combination of economic variables—recovering housing and employment data balanced by decelerating corporate earnings, sales, and capital spending—should support the Fed’s intention to keep short-term borrowing rates low for the foreseeable future.

Improving credit fundamentals
The sustained economic improvement in the U.S. has helped states slowly recover from the recession, which has been reflected in tax revenues that have rebounded to peak levels (see the chart right). Improved financial footing allowed nearly all states to achieve on-time budgets in 2012 through a mix of spending cuts, revenue enhancements, and draws on reserves. These measures have enhanced municipal bond valuations.

In our view, the prevalence of fiscal conservatism across state governments—with a focus on reducing looming pension and future employee health care liabilities while limiting spending on new projects—should continue to enhance credit metrics.

Limited supply relative to demand
Despite increased municipal issuance in 2012, net new supply actually declined. While refinancing activity surged, new project issuance was down. Limited supply was met by steady investor demand for municipals, fueled by an elevated level of bond redemptions (i.e., maturities and calls), whose proceeds were often reinvested back into the market. A favorable imbalance of demand relative to supply could continue, especially in light of potentially increased demand spurred by higher tax rates.

The case for municipals

With interest rates so low, it is understandable that some investors may be nervous about their bond investments. Municipal bond investors might be feeling additional uncertainty with the high-profile difficulties of Illinois, Puerto Rico, and several California cities. Given these sentiments, how should investors adjust their municipal allocations at this point in time?

In our view, the key for investors is to understand the potential for many market scenarios. An overall asset allocation should be designed to perform well in a variety of scenarios, including one in which U.S. growth continues to be slow amid global uncertainty.

With municipal bonds, investors gain the additional advantage of tax-exempt income, whose value has been enhanced by recent tax increases and the new 3.8% Medicare tax on unearned, nonmunicipal investment income. Note that municipal bonds are generally exempt from federal income tax and conditionally exempt from state and local taxes.

In addition, the security pledges, taxing powers, and balanced budget regulations underlying the asset class have contributed to a remarkable record of historically low defaults and high recovery rates relative to corporate bonds and other types of fixed income securities.

In the current environment, where state revenues continue to recover, municipal defaults remain low, fiscal austerity prevails among issuers, and the level of supply is manageable, municipals should add stability and tax-efficient income to investors’ portfolios.

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1. Source: Reuters, Aug. 11, 2011. http://uk.reuters.com/article/ 2011/08/11/us-bankruptcy-rhodeisland-idUSTRE77A2PE20110811.
2. Source: Government Development Bank for Puerto Rico, Jun. 8, 2012. Data as of Mar. 31, 2012.
The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments. Fidelity does not assume any duty to update any of the information.
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The municipal market can be affected by adverse tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Interest income generated by municipal bonds is generally expected to be exempt from federal income taxes and, if the bonds are held by an investor resident in the state of issuance, from state and local income taxes. Such interest income may be subject to federal and/or state alternative minimum taxes. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Generally, tax-exempt municipal securities are not appropriate holdings for tax-advantaged accounts such as IRAs and 401(k)s.
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