A Low-Risk Way to Tap the Risky Muni-Bond Market

Rarely has the normally unglamorous municipal-bond market been so much in the spotlight. Financial analyst Meredith Whitney recently went on 60 Minutes to predict disaster in the muni market amid a surge of defaults by cities and counties. The dreadful public finances of state and local governments are front-page news. “I’m not sure I’ve seen a time of greater uncertainty in our market,” says Mark Sommer, co-manager of Fidelity Intermediate Municipal Income (symbol FLTMX), a member of the Kiplinger 25.

Consider some of the blows absorbed by the muni market in recent weeks. Interest rates on Treasury bonds rose, eating into muni-bond prices (bond prices move in the opposite direction of interest rates). Congress extended the Bush tax cuts and ended the Build America Bond program, both of which are negative events for the tax-free muni bond market (BABs are federally subsidized taxable muni bonds that provided a cheaper source of financing for their issuers).

From late October through mid December, Fidelity Intermediate Muni shed 2.4%, compared with a 3.9% decline for the Barclays Capital Municipal Bond Index. Year to date through December 29 the fund gained 2.6%, slightly ahead of the index. Fidelity Intermediate yields 3%, as of mid January, which is equivalent to a taxable yield of 4.6% for someone in the top federal tax bracket of 35%.

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Sommer says that market volatility has created some attractively priced muni bonds but he adds that investors must pick and choose carefully among the tens of thousands of issues. For instance, he’s been looking at health-care munis because “there’s been kind of a knee-jerk reaction” to the potential impact on hospitals from health-care reform. “We spend a lot of time understanding which names are essential, resilient market leaders,” he says.

In recent months, Sommer says, he’s sold a number of munis with triple-A and double-A credit-quality ratings because he thought they had become richly priced. He considers lower-grade single-A bonds the most attractive on the municipal credit spectrum and has also increased his fund’s holdings of triple-B issues.

Not surprisingly, Sommer doesn’t think the situation in muniland is nearly as dire as what’s painted by the media. He notes that tax revenues have been growing again the past six months and that some state and local governments have made progress in addressing their structural budget issues. Unlike the case of European sovereign debt, to which some compare our muni woes, debt service is a relatively low percentage of U.S. state and local government expenditures.

Moreover, just as in corporate bonds, there is tremendous diversity in the muni market, ranging from pristine to dangerous credits. “If you don’t have expertise, read the newspapers and watch 60 Minutes, then munis are a scary place to be,” says Sommer. “But if you’re set up with a large research staff, as we are at Fidelity, to evaluate bonds on an individual basis, then this market doesn’t seem so scary.”