This Kiplinger 25 Fund Manager Navigates New Turf for Tax-Free Bonds

Mark Sommer, manager of Fidelity Intermediate Municipal Income (symbol FLTMX), is posting respectable numbers, as usual. His fund, a member of the Kiplinger 25, has returned 5.3% this year through August 24, a smidgen behind a basket of like funds (a difference of 0.4 percentage point, to be precise). So what has changed on Sommer’s turf? The real question is, What hasn’t?

For one thing, the tax-free-bond market has been turned upside down since the implosion of muni insurers during the 2007–08 financial crisis. Sommer says that as recently as three years ago, at least 50% of muni issues were insured, a blessing that typically conferred a triple-A rating on the bonds. Today, less than 10% are insured, and new triple-A-rated credits have become scarce.

Budgets of local governments are under severe stress, but Sommer thinks they can manage. “State and local governments are not auto companies with pension liabilities,” he says. “They have taxing authority. They can’t print money, but they can cut employment.” Like many other muni-bond managers, Sommer expects defaults to tick up, perhaps to double, but that would still be an extremely low failure rate compared with the rate at which corporate issuers default.

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Sommer and his team of 15 analysts add value by carefully analyzing muni issuers and their bonds. When the bond insurers reigned, tax-free bonds were almost like commodities; investors often didn’t look closely at the underlying credits -- and, for the most part, they didn’t need to. Now, without the protection of insurance, issues must sink or swim on their own merits, or lack thereof.

Muni-bond prices aren’t cheap, but Sommer says he’s still finding value in some single- and double-A-rated paper. For instance, he likes a number of essential-services revenue bonds in the sewer, water and electric-utility sectors. “These services are so essential that people won’t stop paying for them,” he says. “In many cases, the issuers have the flexibility to raise rates.”

Sommer is also buying some municipal-related hospital bonds, though he first assesses each issuer’s vulnerability to potential government cuts in Medicare and Medicaid funding. In the relatively volatile market for general-obligation bonds from Illinois, California and Puerto Rico, Sommer says he can be a buyer or seller depending on the wide swings in the bonds’ prices.

One thing that hasn’t changed in the muni world is the bonds’ attractiveness to those in the highest tax brackets. Muni Income’s yield, based on its latest distribution, is 3.4%. That’s equivalent to a 5.2% yield on a taxable bond for a taxpayer in the 35% bracket (the fund’s 30-day “SEC yield” is 2.2%, presumably reflecting its ownership of many bonds selling above face value). If income-tax rates rise next year, tax-free income will become even more attractive. The fund’s average duration, a measure of interest-rate sensitivity, is 5.1 years. That suggests that the fund’s share price would fall 5.1% if interest rates rose one percentage point (and rise 5.1% in the far unlikelier event that rates fell one point from their current, ultralow levels).

Muni Income’s annual expense ratio is 0.41%, well below the average of 0.92% for the typical intermediate-municipal-bond fund. The minimum investment is $10,000.