The Outlook for Muni Bonds in 2012

Managers and analysts are optimistic yet skeptical that last year’s double-digit gains can be repeated.

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It's a new year for the municipal bond market, a year that's so far sleepy compared to late 2010 and early 2011. Investors will recall that's when noted banking analyst Meredith Whitney sounded, on national television no less, an apocalyptic warning about defaults.

Sleepy is what muni bond investors, who tend to be higher-net-worth individuals nearing or at retirement age, are paying for. In fact, as part of the great search for yield outside of historically low Treasury notes and bonds, some managers are increasingly turning to select munis to help round out investor portfolios.

[See Where to Invest in 2012.]

In the wake of Whitney's comment in December 2010 on CBS's 60 Minutes, "There's not a doubt in my mind that you will see a spate of municipal-bond defaults," the normally relatively subdued tax-exempt bond market was jerked awake.

Her remarks, based on a thick research report her team compiled over several months, drew fire from the bond industry. But the impact on investors was done.

Some $4 billion in investments flowed out of municipal-bond mutual funds in the week ended Jan. 19, 2011, the most since at least 1992, when Lipper U.S. Fund Flows started tracking the data. That week's outflow marked the 10th straight week of net redemptions, totaling $20.6 billion, according to Lipper. With the exodus, returns on municipal securities were the worst in some 16 years, according to the Merrill Lynch Municipal Master Index.

Some observers hitting the financial circuit in the wake of the Whitney interview pointed to the cascading effect from the federally backed Build America Bonds program. The program, which generated sales of $187 billion of securities, was coming to an end. The rush by state and local governments to issue the taxable securities stole demand from traditional tax-exempt debt, depressing prices. The flurry of defaults never materialized.

[See top-rated funds by category ranked by U.S. News Mutual Fund Score.]

Sure, a slow-growth economy and strained state and local coffers keep muni bond-fund managers and investment advisors on guard. But for the bulk of the industry and its investors, it's back to business as usual.

National longer-dated muni funds logged close to 11 percent gains in 2011. The group added 2.1 percent in the final quarter. California-issued long-dated funds were the category leaders, up 11.7 percent in a rebounding year and 2.3 percent in the quarter. High-yield muni funds, whose higher payout reflects the greater perceived risk of default, gained 10.2 percent for the year and 1.7 percent in the quarter.

Municipal managers and analysts are optimistic about 2012, but most are skeptical that the last year's double-digit gains can be repeated. Managers have simply pared their still-optimistic expectations.

Munis tend to be the choice of higher net-worth individuals looking for tax savings. The cost of entry to this market, particularly for individual bond ownership, can be relatively high. But munis can play a role in a broader bond portfolio, particularly through mutual funds. Of course, there are also costs and fees associated with fund ownership.

[See Should You Invest in Bond Funds or Individual Issues?]

"No doubt, municipalities have faced their share of challenges, including cutbacks in federal aid. But, we felt all along that the headlines were overstating the risk in much of the muni market," AllianceBernstein analysts say in a published outlook.

"State and local governments have been tackling their issues using budget cuts, taxes, fees and other tools. These choices are painful, but the net result is stronger fundamentals than headlines imply," they said.

For investors able to stomach some credit risk, municipal bonds offer attractive compensation currently relative to historical municipal-bond risk premiums. In addition, at many maturities, municipal bond yields are higher than those of their taxable counterparts, even before factoring in the tax exemption of muni bond income.