Risks Gathering in Municipal Bonds

Municipal bonds have enjoyed a fine run. Debt issued by state and local government entities, as measured by the Bank of America Merrill Lynch Municipal Master index, has returned 6.9% annualized over the past three years -- handsome performance by bond standards. Some of that return results from bond-price appreciation, but much of it has come in the form of interest that is exempt from federal income tax.

But the big run, plus large inflows of investor money into municipal bond funds, is making Mark Sommer nervous. "We're being more selective," says Sommer, who manages Fidelity Intermediate Municipal Income (symbol FLTMX), a member of the Kiplinger 25. "It's easier to be selective, and not take on risk, when you're not being paid for those risks."

The world of municipal bonds looks much different than it did five years ago, Sommer says. Prior to the 2008 financial crisis, many bond issuers purchased insurance from triple-A-rated insurance companies. The insurance guaranteed timely payment of principal and interest in case an issuer got into financial trouble, and having such insurance automatically won a bond a triple-A rating. As a result, many investors viewed muni-bond funds as more or less homogeneous. "Pre-market crisis, there was a prevalent impression that muni funds were a commodity," Sommer says.

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That all changed when the insurers began to lose their top-tier credit ratings in 2008, and bond issuers stopped buying insurance. That has led to wider variation in the returns of the underlying bonds, Sommer says.

Returns from the debt of less-creditworthy issuers have surged recently. Over the past year, the average fund that invests in intermediate-maturity investment-grade municipal bonds returned 4.7%, while the average fund that invests in junk-rated muni bonds gained 11.8% (returns are through January 14). After such strong performance, Sommer says, the debt of riskier issuers is generally less attractive.

The same is true of long-term muni bonds. Funds that invest in long-term investment-grade muni debt gained 7.3% over the past year. Sommer avoids making bets on movements of interest rates by keeping his fund's duration -- a measure of interest-rate sensitivity -- close to that of his benchmark, the Barclays 1-17 Year Municipal-Bond index. The fund's current duration is five years, suggesting that its share price would fall 5% if interest rates were to rise by one percentage point (or climb by a similar amount in the less likely event that rates fall by one point).

Sommer is also wary about recent strong inflows of cash into muni bond funds. In the past year, investors have stashed $53 billion of additional money, net of withdrawals, into muni funds, according to Morningstar. Sommer believes some of that money could be coming from investors chasing the slightly higher yields that muni bonds pay compared with alternatives, such as money market funds. "As returns become more stingy, investors can't resist the temptation to take on more risk," Sommer says.

He's concerned that at some point, all that cash could run back out the door even faster than it came in. To mitigate that risk, he's favoring bonds that are widely traded; they should be easier to sell at a good price if he needs to raise cash in a hurry.

Sommer does see a few opportunities among muni bonds. For example, he likes debt issued by certain hospitals that he believes are likely to be bought by financially sturdier health care systems. Such deals could improve the acquired hospitals' creditworthiness.

Because of Sommer's caution, Fidelity Intermediate Muni has lagged its peers in recent years. The fund's 4.9% return in 2012 trailed the average in its category (intermediate-maturity funds that invest in investment-grade munis) by 0.7 percentage point; its three-year annualized return through January 14 of 5.2% lagged the category by an average of 0.4 point per year. The fund sports a current yield of 1.4%.

Despite his concerns about risks, Sommer says municipal bonds are still attractive compared with other bonds of similar quality. For example, the current average triple-A-rated municipal bond yields 1.7%, compared with a yield of 1.9% for ten-year Treasury bonds. For a taxpayer in the highest federal tax bracket of 39.6%, a 1.7% tax-free yield is equivalent to 2.9% from a taxable bond. Says Sommer: "Investors have become worried that maybe the muni market has become a much riskier place to be. But over time, it has proved to be one of the more resilient asset classes."

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