A muni opportunity

The tax efficiency, income potential, and quality of municipal bonds is attracting investors.

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Key takeaways

  • Municipal bonds have gotten off to a strong start in 2019 with $35 billion flowing into muni mutual funds and ETFs in the first 4 months of the year.
  • The federal tax changes that took effect last year are helping drive demand for munis while also reducing the supply of bonds in the market.
  • Despite concerns about some states' finances, municipal bonds continue to offer investors potential tax-free income and high credit quality.

For decades, investors have looked to the municipal bond market to provide reliable income that in many cases is exempt from taxes. Many experts expected that the 2017 overhaul of the federal tax code would reduce demand for munis, but so far in 2019 the opposite has happened.

Chris Pariseault, CFA©, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, explains that the tax code changes have in fact strengthened the traditional appeal of muni bonds for investors seeking tax-smart sources of income. We spoke with him recently about where and how the municipal bond market may offer opportunities for investors today.

The muni market has been off to a terrific start so far in 2019. That's surprised some people. Why has this happened?

Pariseault: Some investors may have been caught off guard by the impact of the 2017 Tax Cuts and Jobs Act, which was the first major overhaul of the federal tax code since the 1980s. Late last year, when it came time to plan for taxes under the revised code, investors anticipated that the act was going to lower marginal rates. Many assumed that they wouldn't need as much tax-exempt bond exposure and demand waned. But investors in high-tax states such as California and New York have ended up facing higher taxes because tax reform capped the amount of state and local taxes they were able to deduct on their federal returns. When they realized their overall tax bills were likely to increase as a result, demand for tax-exempt bonds went up.

How is the rush to munis by investors in those high-tax states affecting the municipal bond market overall?

Pariseault: The increased demand has pushed prices up broadly and I expect demand to stay strong for at least the rest of 2019. This, of course, is affecting valuations in the market which are rising a bit. However, the ratings and credit quality of municipal bonds are typically higher than those of investment-grade corporate bonds. Munis can also provide steady streams of tax-exempt income that may be attractive for investors in higher tax brackets.

So is this increase in demand from investors the only reason for the strong performance of the muni market so far this year?

Pariseault: Supply is part of what's driving the market as well as demand. Besides capping the deductions for state and local taxes, tax reform also eliminated the economic incentive for bond issuers to issue "advance refunding" bonds. Advance refundings let issuers refinance outstanding bonds that would otherwise not be callable by issuing new bonds at lower interest rates and using the proceeds to pay off the outstanding debt. By changing the rules for advance refundings, the government effectively reduced the amount of new bonds that would otherwise be issued in a typical year by 20% to 25%.

Historically, the default rates for muni bonds are very low, but for a while now there has been a lot of talk in the media about the financial problems facing many of the same high-tax states where demand for munis is coming from as a result of tax reform. Are there investment risks lurking in bonds issued by states such as Illinois, New Jersey, and Connecticut where structural issues such as underfunded pension liabilities exist and where the political system has struggled to balance budgets and manage public finances?

Pariseault: The unfunded pension liability problem varies greatly by issuer so investors should not paint the entire market with a broad brush. Most states and cities have been taking steps to address these types of issues. Since the global financial crisis, almost three-quarters of the states and more than half of all local governments have made changes such as reducing pension benefits and increasing employees' contributions to retirement and health care programs. However, pension obligations for certain states can be as much as one-third of their general fund spending and some have struggled with this increasing expense, especially where it has been difficult to raise revenues.

So for example, Illinois has unfunded pension liabilities, but it also has a diversified economy with a large corporate presence, high incomes, and some of the world's most productive farmland. Does that mean that its strengths outweigh its much-publicized difficulties in passing budgets, and does that imply investment opportunities may exist in its bonds?

Pariseault: Skilled, professional bond managers may be able to find instances where the market is mispricing bonds due to the media’s focus on unfunded pension liabilities. This can create investment opportunities. State bonds may be oversold on concerns about pension liabilities and this may produce opportunities. You see this sort of thing in the muni markets all the time. Politically charged headlines may obscure the underlying quality of the bonds which offer attractive prices, income-tax efficiency, and less risk than headlines and market sentiment may suggest. However, there may be instances where credit risk and volatility are high and caution is warranted.

For individual investors who want to add munis to their portfolios, how do you suggest they research bonds to decide what may be right for them?

Pariseault: First, they should think about what they want an allocation to munis to do for them. It may be to provide tax benefits, it may be to provide income, or it may be to fund a specific need in the future such as college tuition. Once they've determined what they want to accomplish, the next step is to select an approach. Mutual funds offer investors a convenient way to gain exposure to the municipal bond market as well as the potential to benefit from the skill of professional managers who may find opportunities in what remains a relatively fragmented and inefficient market. If you can align a fund with a specific investment goal, you can gain access to all the tools that professional management offers.

Some funds hold bonds issued by municipalities across the country while others hold only bonds from issuers within a single state. What should an investor consider when choosing between a state-specific fund and a national municipal bond fund?

Pariseault: It's a great question and one that we get all the time. The decision really hinges on the tradeoff between tax-efficiency, diversification and investor choice. In many instances, if an investor wants to maximize tax-efficiency a state-specific fund can provide tax-exempt income at the state and federal level. A national fund's income can be taxed at the state level for bonds owned outside of that investor's home state. By investing in a state specific fund, a significant trade-off is the diversification that a national fund can provide across geographies, issuers and revenue types. Also in low rate environments, the tax advantage of state funds may not be as compelling as national funds which could have a yield advantage after adjusting for state taxes. An investor will have a choice across many different types of state and national funds at points all along the maturity spectrum. This decision will of course also be influenced by the investor’s time horizon and risk tolerance.

Finding municipal bond ideas

Fidelity's mutual fund and ETF screeners can help you find municipal bond investment ideas. (Note: These results are illustrative and are not recommendations by Fidelity or the fund managers.)

Mutual funds holding municipal bonds issued by states and cities nationwide Mutual funds holding municipal bonds issued within a single state Municipal bond exchange-traded funds
Fidelity Funds
Fidelity Intermediate Municipal Fund (FLTMX) 
Fidelity Municipal Income 2023 Fund (FCHPX)
Fidelity Limited Term Municipal Fund (FSTFX)

Other funds
Goldman Sachs (GSMIX)
Blackrock National Municipal Fund (MDNLX)
Principal Tax-exempt Bond Fund (PTEAX)
Fidelity Funds
Fidelity California Limited Term Tax-free Fund (FCSTX)
Fidelity Massachusetts Fund (FDMMX)
Fidelity Minnesota Municipal Income Fund (FIMIX)

Other funds
Eaton Vance Georgia Municipal Income Fund (ETGAX)
PIMCO New York Municipal Bond Fund (PNYAX)
USAA Virginia Bond Fund (USAVX)
American Century Diversified Municipal Bond ETF (TAXF)

iShares National AMT-Free Muni Bond ETF (MUB)

iShares Short Maturity Municipal Bond ETF (MEAR)

iShares California Muni Bond ETF (CMF)

iShares New York AMT-Free Muni Bond ETF (NYF)

Next steps to consider

Get investment analysis to help you invest in bonds.

Review your bond holdings and see your interest rate risk.

Read more Viewpoints articles on bonds.

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