Municipal Bonds: What a Difference a Year Makes

Last year at about this time, the municipal bond market was in the midst of a selloff of historic proportions. Franklin Templeton’s Municipal Bond Department Co-Director, Rafael Costas, was quite vocal during that period in the face of what his team viewed as an unnecessary panic. What a difference a year makes! The panic has subsided, and now, John Wiley, portfolio manager for Franklin High Yield Tax-Free Income Fund, offers his voice to the conversation. According to Wiley, now’s an exciting time for investors to consider this asset class, which he feels is on firmer footing today. In brief:

• We believe the fear and dire predictions about municipal bonds last year were largely unfounded and misguided.
• We think the municipal bond market is now trading on strong fundamentals.
• Fiscal constraints remain in the marketplace; we need to be disciplined and responsible in our investing.
• In our opinion, it’s nonsensical to compare the U.S. municipal marketplace to sovereign-debt countries.
•  We are staying more defensive; we think it’s the most prudent course of action.

Debt has been a hot-button issue over the past couple years, from the sovereign level down to the local level. U.S. municipal bonds have felt the impact, experiencing a big selloff in early 2011 as fearful investors unloaded these holdings in staggering numbers.  According to the Investment Company Institute (ICI) investors withdrew more than $40 billion in funds from November 2010 through May 2011.¹ Wiley saw the time of panic as a time of opportunity.

“A great deal of panic had taken hold in our marketplace as outside analysts were predicting hundreds of billions in defaults in the municipal bond market. What we’ve come to find is that much of the fear—and those projections—were greatly unfounded and also, in our view, greatly misguided. But once that fear subsided, the market rebounded quite well.”

Today, Wiley believes the fundamentals look solid for municipal bonds, and even though yields have plummeted, ratio analysis with respect to Treasury, corporate and mortgage yields looks favorable. In addition, if tax rates rise (we are in an election year, after all), he sees an even more compelling case for munis as a core part of investors’ portfolios.

That’s not to say there aren’t risks. Many state and local governments still face significant fiscal strains, including burgeoning entitlements and pension liabilities. Perhaps you’ve read about bankruptcies in California cities Vallejo or Stockton. Wiley cautions that it’s important to make distinctions between debt on the country, national, state and local level—and not to compare apples to oranges.

“We’ve read and heard about the concern of cities and states and their amount of debt, and comparing them to sovereign countries like Greece. Greece’s debt to its gross domestic product ratio is over 150%.²  The State of California’s net debt to its gross state product is about 5%.³ Those are very different debt profiles, and  California is one of the lowest-rated states in the country; most states have a better debt profile than California.

The same is true for local municipalities. The type of debt that you see in Vallejo and in Stockton and some other cities is very limited in scope. I urge investors to understand this fact when they consider municipals as part of their portfolios. Even if you have the ultimate bankruptcy, there is a stay in those payments; it’s still a tax lien. That debt is being paid regardless of where the city is in terms of bankruptcy or insolvency. We think it’s just nonsensical to compare our municipal marketplace to other sovereign debt countries.”

Discipline is Key

So now that we’re comparing apples to apples, Wiley’s job is to do his best to avoid the rotten ones, which to him means a disciplined vetting process.  

“We are more defensive, but we think it’s the most prudent course of action. We can’t over-emphasize the need to have research and support, and be diversified. Some other funds employ aggressive leverage and hedging techniques and strategies to enhance their yields. We don’t think that is appropriate for many investors—we don’t have to go back very far to see what leverage can do to a portfolio when the market goes against you.”

Sir John Templeton certainly understood how difficult the vetting process can be. In his words, “Successful investing is not an easy job. It requires an open mind, continuous study and critical judgment. Changes of trend occur when least expected.”

Get more information about the basics of investing in municipal bonds.

Learn more about the Franklin High Yield Tax-Free Income Fund.

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What are the Risks?

All investments involve risks, including the potential loss of principal.  Because municipal bonds are sensitive to interest rate movements, the fund’s yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. The fund is actively managed but there is no guarantee that the manager’s investment decisions will produce the desired results. In general, an investor is paid a higher yield to assume a greater degree of credit risk. These and other risks are described in the Franklin High Yield Tax-Free Income Fund’s prospectus.