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In times of turmoil, muni bond funds offer stability

If the stock market has you feeling seasick, could muni bonds be your port in a storm?

Municipal bond funds delivered a stellar 9.8 percent return in 2014, thanks in large part to a Federal Reserve interest rate hike that never happened. Experts say a repeat performance is unlikely, but munis may still offer a place for investors to wait out broader market turmoil.

One factor in the plus column for municipal bonds is new issue volume. Municipalities have been issuing more bonds this year than last, which has led to softer prices. But Christopher Alwine, head of the municipal bond group at Vanguard, which oversees $147 billion in muni assets, estimates that roughly 60 percent of munis issued this year will be refinancing, so the net new volume will be less than the actual volume of new bonds.

"Debt issuance in the muni market has been more robust in 2015, driven largely by issuers trying to capitalize on today's lower interest rates before the expected Federal Reserve rate hikes," said Elizabeth Foos, a senior analyst at Morningstar, in a midyear report.

When that hike will happen remains uncertain, particularly in light of the latest jobs report and recent market volatility. But Alwine expects 10-year Treasury rates to be range bound between 2 and 2.5 percent for the next year. "You have growth that is good, not great, but good, and you have inflation that is closer to bottoming," he said.

Chris Dillon, global fixed income portfolio specialist at T. Rowe Price, which has a $22 billion muni platform, also sees 10-year Treasury yields at roughly 2.5 percent by year-end, but the firm does expect the Fed to raise rates, possibly in September.

In the minus column is the increasingly precarious state of several states' and cities' finances. New Jersey's pensions are woefully underfunded, for example, and Chicago's debt was downgraded this year to below investment grade.

Those troubles have added resonance for muni investors holding general obligation bonds, backed by an issuer's general revenue from sources like taxes, because of how Detroit treated its debt in bankruptcy. After first labeling the bonds unsecured debt, the city ultimately wound up paying bondholders 34 cents to 74 cents on the dollar.

As a result, a number of muni pros have lightened up on general obligation municipals. T. Rowe Price is overweighting essential services revenue bonds, Dillon said, with about 81 percent of its muni portfolio in revenue bonds, compared with their roughly 66 percent share of the overall market. (A revenue bond is a municipal bond supported by revenue from a specific income-producing project, like a toll bridge or local stadium.) The firm's New Jersey fund holds no general obligation bonds, he added.

Vanguard is also overweighting revenue bonds, Alwine said. The degree varies by fund, but in general it is in the 5 to 10 percent range.

Another challenge for muni bond investors is the changing landscape of municipal bond insurance, which can be purchased by investors to ensure that a muni bond's interest and principal will be paid on time if the bond issuer is unable to do so. At the time of the financial crisis, some 55 percent of municipal bonds were insured, and more than 70 percent carried a rating of AAA (the top rating), Dillon said.

But the insurers were hurt by venturing into mortgage-backed securities in the years leading up to the financial crisis, and several lost their AAA status. Just 5 percent of new muni issues carries insurance, and many major bond insurers have lost their AAA credit ratings.

Given all these shifting trends, experts suggest keeping these tips in mind when considering a muni bond investment.

Dillon recommends national funds, rather than state funds that could leave investors overexposed to a local financial problem. If you are determined to lock in the added tax exemption provided by a fund specializing in muni bonds from your state, "look underneath the hood" to see what the fund owns, he said.

Foos recommends taking a close look at the quality of the research by a fund's managers. Bond issuers can be somewhat opaque when it comes to disclosure, she said, so expertise is key.

It's important to manage expectations too. Munis may not deliver stellar returns this year. But Alwine said they still have a role to play.

"What the stock market has been going through recently is why you own bonds," he said. "They still serve as a diversifier, stabilizer and an income producer. They still have a place in investors' portfolios."