Pity the poor municipal bond fund managers. Every few years, they are called on to defend the sector in the face of worries about a debacle in the muni market.

This is another of those times. Among the reasons that bears are wary of the muni market: Detroit's default last summer, Puerto Rico's looming (as of mid-January) downgrade, Illinois' mounting pension obligation and the Federal Reserve's decision to begin tapering its $85 billion monthly bond-buying program. The S&P Municipal Bond Index was down 2.3% for the year that ended on Jan. 7 - ouch.

But Christopher Alwine, head of Vanguard's municipal bond team, has seen this before. He has been managing municipal bond funds since 1991, and over that period he has witnessed some bleak times.

In 2008, the worldwide financial collapse seized up credit markets - and bond insurers, once ubiquitous, experienced credit problems all their own. That led investors to question the creditworthiness of munis and the eventual departure of insurance from the market.

The worst fears passed - until 2011, when prominent banking analyst Meredith Whitney predicted a massive wave of municipal bond defaults. (They didn't happen.)By comparison, Alwine says, today's worries are relatively modest. "When munis have a bad year, it's not all that bad," Alwine says of the recent dip in the sector's performance.

Rare Defaults

Although muni default rates are on the rise since the financial crisis, they are still extremely unusual. According to Moody's Investors Service, the default rate for munis rated by the firm is 0.03% over the last five years.

In recent years, the fortunes of the overall muni market have shadowed the Vanguard Intermediate-Term Tax-Exempt bond fund (VWITX), the largest of the muni funds overseen by Alwine's team. In 2012, as hungry investors looked for yield advantage, munis were a natural place to get it with relatively little risk. The fund saw strong inflows. But 2013 proved something else, amid the Detroit bankruptcy and fears about an impending ratings downgrade for Puerto Rico. The fund lost $4 billion to outflows. Vanguard was hardly alone. Lipper reported that, in the first 11 months of 2013, investors withdrew $52 billion from muni bond funds. That's the most since at least 1992, when Lipper began tracking the flows.

James D'Arcy, who took the reins of Vanguard Intermediate-Term Tax-Exempt last June, just as the fund was closed to new investors, chose to reopen it six months later as money began to leave.

As with other offerings in the intermediate tax-exempt field, Vanguard's performance is off over the last 12 months. It was down 1.3% for the year ended Jan. 7, although that was still in the category's top 24%. Over the past three years, the fund is up an annualized 4.6%, besting 73% of its peers.

The Case for Owning

Despite the headlines, Alwine says, the case for munis is strong. First of all, the income produced by munis is tax-free; that is especially important now that the net investment income of high-income individuals is subject to a 3.8% Medicare surtax.

And when problems do flare up in the muni market, they don't tend to be contagious, Alwine insists. Part of this has to do with the sheer number of issuers - there are tens of thousands of them. In addition, the financial troubles in one jurisdiction tend to be unique. So, highly publicized troubles in a few locations aren't necessarily symbolic of difficulties throughout the market.

Underrated Attributes

General obligation bonds, backed by a municipality or state's taxing authority, make up the lion's share of the fund's holdings. Yet Alwine also believes that a way to improve performance is to look for certain attributes in bonds that may be out of favor with a majority of investors and therefore could add a few basis points.

One of these categories is longer-dated bonds. The Fed's tapering stance puts pressure on the longest bonds, since these bonds are more sensitive to interest rates. In this environment, investors tend to cluster in the shorter part of the yield curve - but Alwine believes that a long-term investor can get a yield pickup without sacrificing performance. "We like the eight- to 10-year maturity a lot," he says.

Though he's concerned that defaults are on the rise, Alwine notes that they are still rare among investment-grade bonds and more common in junk bonds, those rated BB and lower. Health care is another area where Alwine and the managers who work for him think there is value. Changes are coming to the sector now that the Affordable Care Act is in place. This presents opportunity, but also calls for caution. About 10% of the fund's assets are in public health care-related issues, compared with 6% for the Barclays Capital 7-Year Municipal Bond Index.

Nonetheless, Alwine notes, "There will be winners and losers and consolidation." Because of this, security selection is paramount.

Vanguard prefers the larger health care systems that have invested in technology and are on track to realize cost savings. Alwine also has a bias toward health care issues in the 25 states that have expanded Medicaid coverage, saying the expansion gives those states more money to spend on health care - which could in turn increase demand for medical services. Even so, Alwine has stayed invested in bonds rated A or higher.

The fund managers like larger hospitals that are leaders in their market and are therefore well-positioned for the changes of the Affordable Care Act. But they also like smaller medical centers that might be the No. 1 player in their area. "You could see some mergers that could result in upgrades," Alwine says.

Ilana Polyak has contributed to Financial Planning, The New York Times, Money and Kiplinger's.




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