Morningstar Advisor - August/September 2012 - (Page 39)

bonds with higher payouts, tend to offer more attractive income streams than what an investor could buy directly. In a rising-yield environment, the reverse happens: Investors prefer to lock in a higher yield by purchasing bonds directly as fund payouts lag behind. As muni yields have plunged over the past year, refunding activity—issuers replacing higher coupon bonds nearing their call dates by issuing new bonds—has picked up, leaving individuals with cash to reinvest in a climate of painfully low yields. As long as that trend persists, it could support ongoing inflows to muni funds. (Unfortunately, muni funds themselves face the same problem: As their higher coupon bonds get called away, they’re forced to reinvest at current, lower rates.) Whether through funds or direct purchases, continued demand from individual investors is one reason why a sustained rise in muni-bond yields isn’t necessarily around the corner. Demand from individuals plays a unique role in the muni-market compared with other bond sectors, because households own roughly half of the outstanding $3.7 trillion market and mutual funds own another 22%, according to the Federal Reserve’s December 2011 “Flow of Funds” report. So even with muni yields hovering near all-time lows, demand from individuals with few other options for tax-exempt income could remain strong. Muted supply is another factor that could keep muni yields low for now. Although gross muni issuance is expected to pick up from 2011’s low of $288 billion (the norm for the past decade has been closer to $385 billion), roughly two thirds of new supply is because of refundings, according to estimates, a larger portion than usual. Many analysts expect that a rise in refunding activity could contribute to negative net new issuance in the near-term—meaning that redemptions from refundings and maturities could outpace new supply—resulting in fewer bonds available to meet demand. BlackRock’s muni-bond group head, Peter Hayes, also suggests that a broader deleverag- Bad Timing: The best time to buy munis was in January 2011, exactly when yields were rising and investors were fleeing. Assets Municipal-Bond-Fund Flows Barclays Municipal Bond Index Yield % $15 (bil) 10 5 0 –5 –10 –15 4.5 3.0 1.5 07/09 01/10 07/10 01/11 07/11 01/12 0.0 ing trend among municipal issuers could cause the total amount of muni bonds outstanding to decline over the next five years, as the political climate favors frugality over more spending. Flare-Ups Ahead challenging fundamental backdrop. Others, such as Fidelity’s muni-bond team, see opportunity among local government debt where their research gives them an edge. Inadequate funding for future pension and health-care obligations remains another looming problem that must be addressed. A different June Pew report noted that states’ funding gaps for retirement benefits rose 9% in fiscal year 2010 to $1.4 trillion. The report used the states’ own actuarial assumptions for investment returns—8% on average—numbers that have come under criticism for being too optimistic. Still, the report acknowledged that states have undertaken an unprecedented number of reforms that at least begin to address this issue. Rather than viewing underfunded pensions and health-care obligations as an imminent threat to bond payments, most fund managers continue to monitor these situations and factor them into their overall assessment of issuers’ creditworthiness. While poor fundamental trends don’t always directly translate into widespread defaults, even isolated credit trouble can spread to the broad muni market if it makes investors more wary. By now, most agree that the worst default predictions of 2011 were overblown, and munis have been helped by favorable supply-anddemand dynamics in the meantime. Muni investors hate surprises, though, and a number of headline risks and other market factors could shake them out of their complacency. There’s cause for encouragement: Many state and local governments have taken steps to close budget gaps through some combination of hiking revenues and spending cuts, and several studies noted that defaults actually decreased in 2011. Despite signs of improvement, though, the fiscal situation remains grim for many, especially local governments. A report issued by the Pew Charitable Trusts in June noted that many local governments are reeling from the “one-two punch” of reduced state aid and falling property taxes, which make up the lion’s share of local budgets. While there are still many solid credits in this sector and most fund managers expect defaults to occur only in isolated cases, some are treading lightly in this area because of the MorningstarAdvisor.com 39 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2012

Morningstar Advisor - August/September 2012
Contents
Contributors
Letter From the Editor
How Much of the Behavior Gap Is Your Fault?
What’s Your View of the Muni-Bond Market?
A Balanced Life
How to Get to Know EMMA
A Strong, Robust Fund Business
Dividend Investing Abroad
Four Picks for the Present
Investment Briefs
Fund Expenses Through the Decades
Autos on Comeback Track
Lessons From the Muni-Bond Rebound
Municipal-Bond Landscape Shifts
Municipal Bonds 101
A Tale of Two Cities
Unraveling the Mysteries of Money
Small Companies Mean the World to Him
The Chinese Art Market and the Origin of Bubbles
The Myth of the Dumb Investor
Stocks That Can Stand the Heat
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The War on Savers

Morningstar Advisor - August/September 2012