Revenge of the muni bonds

March 17, 2011, 2:35 PM UTC

The latest market upheaval has some investors seeking refuge in a sector that has spent six months getting tagged as toxic – municipal bonds.

The widely discussed threat that stretched state and local governments will default hasn’t gone away, obviously. But the premium valuations that prevailed in the muni sector for much of last year have, thanks to a wave of year-end selling spurred by tax changes, heavy deal flow and a rash of bad headlines.

What next?

The selloff has left some muni bonds, bond funds and exchange-traded funds looking attractively priced for the first time in a long while. That’s a big plus at a time when bond buyers are dabbing at nosebleed valuations on everything from Treasury debt on down.

“The muni storm seems to be passing,” said Rob Amodeo, who manages muni funds for Legg Mason’s Western Asset Management. “We had a lot of selling that was driven by fear, and now that that has passed we are seeing people rediscover the fundamentals.”

The shift comes as the fizz of easy money shows signs of wearing off in some other sectors of the market, such as high-yield corporate bonds. Half a dozen junk deals have been pulled this week as investors reassess the risk-reward profile of a sector that has been a top returner since the Depression scare passed in early 2009.

“Corporates were the easy answer for a long time, but that trade is starting to get pretty crowded,” said Bill Larkin, who manages fixed-income portfolios for Cabot Money Management in Salem, Mass. “You know things are starting to get a little silly when you start to see things like PIK bonds,” a bubble-era contraption that gives issuers the option of paying bondholders with just what they want, still more bonds.

Larkin isn’t swearing off junk bonds altogether. Low rates and a still gathering recovery “will give them some tailwinds for a while,” he says.

But he contends the best values there now lie on the municipal side of the fence. He said he has been buying the Van Eck Market Vectors ETF (HYD) and the Nuveen High-Yield muni fund (NHMAX), to name two.

The Nuveen fund recently yielded 7.56%, which Larkin said looks good next to corporate high-yield funds even before you consider munis’ tax advantages.

The fund is not for faint of heart, to be sure. It invests up to 10% of invested funds in defaulted muni bonds, for instance. The same might be said of munis in general.

Funds continue to flow out of the sector, if at a slower pace than last fall. The outflows show the muni story still has plenty of skeptics. And even fans admit that there are hard days ahead.

State and local governments “are facing severe fiscal headwinds,” Amodeo says. “There are structural imbalances to deal with that are going to take years.”

But what investment doesn’t have fleas nowadays? Consider Treasurys. They have benefited twice in recent weeks from the flight-to-safety trade, driven first by the oil price spike and then by Japan’s catastrophe. If Europe is forced into another bailout or stocks slump again, that trade could take off again.

Yet with the Fed expected to start removing its support for a debt-addled economy this summer, and the federal government grappling with its own bloated budget, there aren’t many people who would tell you the 10-year Treasury is a bargain at a recent yield of 3.2%.

“We are going into the deep end in June,” Larkin said, referring to the planned end of Fed Treasury purchases. “We’ll see then who can swim and who can’t.”

Won’t that be enjoyable.

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