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Muni update: What you need to know now

It’s been a challenging time for the muni market, but there are opportunities.

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About the expert

Thomas DeMarco
Thomas DeMarco, CFA®, is the fixed income trading desk strategist for Fidelity Capital Markets. He provides the institutional tax-exempt and taxable trading groups and clients with general credit and market research as well as credit-specific analysis.

It has been an eventful few months for muni investors. It started with a sharp spike in yields, then, more recently, the Detroit bankruptcy. But other municipalities are seeing economic growth start to improve their balance sheets, and some municipal bonds are offering more yield than comparable Treasuries.

To find out what it all means for muni investors, Viewpoints checked in with Thomas DeMarco, CFA®, vice president and a bond market strategist in Fidelity Capital Markets.

What does the Detroit bankruptcy mean for investors?

DeMarco: Detroit is in the early stages of what will likely be a long process. It’s too early to speculate whether the bankruptcy will have longer-term market effects or how it may ultimately be resolved. For now, though, the market seems to be taking it in stride. The situation in Detroit has been widely followed by market participants, so the possibility of a filing was anticipated and did not come as a surprise.

Some say the muni market is no longer a relatively safe haven. Your thoughts?

DeMarco: I disagree with that. Municipal bankruptcies have been relatively rare—only 648 municipal issuers have filed for Chapter 9 since 1937, according to Chapman and Cutler, LLP. Furthermore, the 10-year cumulative default rate for investment-grade munis is 0.07%, according to the Moody’s 1970–2012 default study. And while that is somewhat backward looking, and, of course, past performance is no guarantee of future performance, 93% of rated issuers are rated “A” or better by Moody’s vs. only 23% for the global corporate market. I don’t think the issues have changed. I just think that the municipal market is finally becoming more transparent. With more transparency, these issues are becoming more publicized. Furthermore, it is natural to have more stress in the markets around major financial crises.

The muni bond market has hit a rough patch. What’s been happening?

DeMarco: June was a tough month for all fixed income investment products. Frankly, the first half of 2013 was one of the worst halves we’ve had in terms of bond performance in about 20 years—and the muni market was no exception. Municipal bonds lost 3.19% for the month of June,1 which was notable considering that the high-yield corporate index lost only 2.64% for the month,2 according to the Bank of America Merrill Lynch indexes.

There also was a considerable amount of volatility in June. The volatility on 10-year municipal bonds was actually higher than during the financial crisis in 2008. The volatility on 30-year municipal bonds wasn’t quite as bad, but still was almost as high as what we saw during the financial crisis. And this was in contrast to volatility on Treasury bonds, which—while elevated—was nowhere near the levels we saw in 2008 and 2009.

What fueled the volatility?

DeMarco: One factor may have been an imbalance between supply and demand as money has come out of the muni market. Investors who pumped a lot of money into municipal bonds in recent years may be thinking about where the next move in rates is going to be and where they want to be positioned.

Another likely factor at the time may have been statements from the Federal Reserve, which led some investors to believe the Fed would not only taper off its bond-buying program but that monetary policy tightening was coming sooner than they had expected. This contributed to a fair amount of rate volatility, despite subsequent statements from the Fed, which has sought to counter some of those perceptions. The resulting volatility has spilled into all sectors of the bond market.

What about state and local budgets? Are they getting healthier?

DeMarco: The environment remains challenging. On an inflation-adjusted basis, municipalities still are not back to where they were before the financial crisis. But budgets have improved. A number of states are starting to reinstate some of the spending they had to cut back on, especially in education. And I think the purse strings are slowly loosening up and probably will continue to loosen into 2014.

But a slowing economy could change that if it looks as though we’re going to move back toward a recession—that scenario would impact economically sensitive revenues. But I don’t believe anybody is forecasting that scenario, so it would obviously represent a surprise.

Where are you finding opportunities in the muni market?

DeMarco: I am pretty positive on the relative value in the sector as of early July. I look at muni bond yields compared with Treasuries and high-grade corporate bonds, and in both cases munis look fairly attractive. In fact, munis are trading above 100% of Treasuries pretty much across the yield curve, which basically discounts the tax exemption on muni bonds. A long-term average on the 10-year spot of the curve (back to 1981) is around 82% of Treasuries.

Yield spreads versus the AAA muni curve have widened in both the water and sewer and the airport sectors, making them somewhat more attractive. I think yields backing up in these sectors is just a factor of the recent sell-off and not a sign of credit issues. A lot of bonds hit the market in June, and when you have that kind of supply-and-demand imbalance, spreads are going to have to adjust.

I had been favoring the housing sector, but I have grown more neutral on it very recently. Housing-related muni bonds typically have fared better than other sectors during fixed income bear markets. That trend has held this year: Year to date, the housing sector has handily outperformed all other municipal sectors, with a 4.6% excess return (return over a duration-matched basket of Treasury securities) vs. 1.31% for the muni index overall.3 But at this point, the sector is not as cheap as it was at the beginning of the year.

Do you see any other issues on the horizon in the muni market?

DeMarco: There have been a lot of headlines over the past couple of years about placing some sort of limitation on the tax exemption of municipal bonds. Some policymakers have called for an outright elimination of it. But right now, to me, it seems that the pendulum is swinging back toward the preservation of the tax exemption. In fact, 138 members of Congress recently signed a letter saying they want to protect the tax-exempt nature of municipal bonds.4 That’s a positive for municipal bond investors if it holds. Also, Senator Max Baucus was quoted in the press recently as saying that the Finance Committee may mark up a bill on tax reform this fall and investors would be well served to monitor its contents.

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Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
The information presented above reflects the opinions of Thomas DeMarco as of July 31, 2013. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
Past performance is no guarantee of future results.
Diversification and asset allocation do not ensure a profit or guarantee against a loss.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
The municipal market can be affected by adverse tax, legislative, or political changes, and by 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.
Moody’s is an independent organization that assigns credit ratings to debt instruments and securities to help investors assess credit risk.
The AAA muni curve is written and produced by Thomson Reuters Municipal Market Data (MMD) daily to represent a fair value offer-side of the highest-grade AAA-rated state general obligation bonds, as determined by the MMD analyst team.
1. As of 6/30/2013. The BofA Merrill Lynch U.S. Municipal Securities Index measures the total return on tax-exempt investment grade debt publicly issued by U.S. states and territories, and their political subdivisions, including price and interest income, based on the mix of these bonds in the market. The index is often used as a reference for the performance of tax-exempt U.S. municipal bonds.
2. As of 06/30/2013. The BofA Merrill Lynch U.S. High Yield Index is a market capitalization-weighted index of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule and at least $100 million in outstanding face value. Defaulted securities are excluded.
3. As of 6/30/2013.
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