Last year was supposed to be the municipal bond market's Armageddon. Yet the year ended not with the wave of defaults that many predicted, but the types of returns of which other asset classes could only dream.

Sure, municipalities are still under severe financial strain. The lukewarm economy continues to sputter, but the defaults never materialized. Investors have returned to munis in the last 12 months based largely on the strong gains. The typical fund in the intermediate municipal category returned 9% in 2011, according to Morningstar. The S&P 500 posted just a 2% gain.

Veterans like John Pomeroy, lead manager of the $3 billion Franklin Federal Intermediate-Term Tax-Exempt Income fund, see this type of drama from time to time. Normally, this asset class beloved by retirees and the 1% is boring. But when headlines turn on munis, as they did in 1994 in the wake of the Orange County, Calif., default and in 2008, at the height of the credit crisis, Pomeroy uses the negative sentiment to his advantage. "Rates were as attractive as I'd seen them in the 25 years I've been here," he says about last year's market.

Yields were juicy, indeed. The Bond Buyer 20 index flaunted a yield of 5% in late February 2011, while 10-year Treasuries traded at 3.5%. Usually, munis yield 85% of Treasuries. But when their yields exceed that of Treasuries, experienced investors know the anomaly will be short-lived.

This year looks to be more typical and less rewarding. He cautions investors not to expect a repeat. "If you look at how munis react to strong markets historically, they don't happen in succession," he says.

Pomeroy knows the ebbs and flows of the municipal bond market. He has managed the fund since 1992 and has been with San Mateo, Calif.-based Franklin since 1986. For the three years ended Feb. 28, his fund returned 7.8% a year annualized, placing it in the top 25% of municipal national intermediate funds. For the five years ending Feb. 28, the fund climbed an average of 5.3% a year annualized, besting three-quarters of similar funds.



The most recent trouble began in late 2010 when investment analyst Meredith Whitney declared on 60 Minutes that municipal defaults would total hundreds of billions of dollars in the next 12 months. Investors spent the first few months of 2011 pulling money out of munis. But by mid-year, it was clear Armageddon had been averted.

In fact, municipal defaults plunged last year, totaling just $2.1 billion, down from $2.8 billion the prior year. Muni defaults are exceedingly rare to begin with. From 1970 through 2008, no municipal bond rated Aaa, the highest rating by Moody's Investors Service, failed to pay its debts. The rate for bonds with an investment grade was only 0.06% during that time frame.

The reason? Towns, cities, counties and states have a distinct power that corporations don't: taxing authority. A company can't compel customers to buy more of its product when times are tough, but a municipality can raise taxes to recoup lost revenue. Governments nationwide have cut costs and raised taxes as the economy sputtered.

"What we've seen in the last year should help the muni market structurally going forward," Pomeroy says. "Localities are adjusting to overly accommodative periods and are making those necessary adjustments throughout this cycle."



Pomeroy manages the Franklin portfolio for yield rather than total return, believing that shareholders use the fund to supplement their incomes. He finds the highest yielding fare without veering from high-grade bonds, as his fund's prospectus mandates. After years of low rates, Pomeroy was able to boost the portfolio's average yields. Much of the current portfolio is a product of these changes and now Pomeroy is holding steady.

Despite the great bargains, Pomeroy also had to contend with fund outflows. To raise cash, he sold off pre-refunded bonds. These bonds are linked to escrow accounts invested in Treasuries that are used for bond payments and are seen as ultrasafe. In a market where fear reigned, relatively safe bonds fetched attractive prices.

With the proceeds he purchased essential service bonds for projects such as electric utilities, and water and sewer initiatives. He liked the dedicated revenue streams backing the bond payments. One, the Los Angeles Department of Water and Power, has a 5.25% coupon maturing in 2023.

General obligation bonds, too, were on Pomeroy's buy list. "When Meredith Whitney talked about massive defaults, much of it was directed at GOs, so the focus for retail investors was essential revenue bonds," Pomeroy says. "GOs started to trade close to or even right behind revenue bonds."

California, which now has $969 billion in public debt and is coping with dire budgetary problems, was the place many investors directed their wrath. Pomeroy took a different view of his home state.

"We recognized that the legislative process in California is dysfunctional," Pomeroy says. California has flirted with default in years past and Pomeroy's experience told him that the state would make good on its bonds. He was vindicated. Pomeroy was able to snag California State General Obligation bonds due in 2021 with a 5.5% coupon. "California was one of the best performing states last year," he says.



Another tactic that worked in last year's sentiment-driven market was buying bonds due within 10 to 12 years. Fearing defaults, investors tended to favor shorter-dated bonds, believing the issuers were less likely to shirk their debts. The gap in yields between short- and long-dated bonds widened.

This difference in short and long rates, known as the yield curve, continues to be wide. "For us right now, we're finding value in that 10- to 12-year frame," Pomeroy says. "That's because of the steepness of the yield curve."

Longer-dated bonds, though, carry more interest rate sensitivity. When interest rates spike, their prices will suffer since yields and price have an inverse relationship. The Franklin fund does trail during such periods. Pomeroy is not so concerned with that scenario for the time being because "the Fed has been very accommodative," he says.

Since 2008, the muni market has undergone a profound change with the retreat of the bond insurers. From the late 1990s through 2008, more than half of new issues that came to market had bond insurance.

When the financial crisis hit, it turned out that bond insurance firms such as Ambac and MBIA did not have the financial wherewithal to protect investors against a rash of defaults. Since then, 95% of new issues that come to market are backed only by an entity's own creditworthiness. "Certainly, the 17 analysts we have now are working much harder since 2008 when risk premiums were nothing," Pomeroy says.

He now must contend with a limited new issue calendar. He prefers to purchase bonds in the new issue market, which provide the best opportunity for the characteristics he seeks, not to mention a 0.05% to 0.10% yield pickup.

"In this political climate, a lot of states don't want to be out there borrowing a lot of money," he notes. If the experience of the last year is any guide, though, it's only a matter of time before sentiment changes in the investor's favor.



Ilana Polyak, a New York writer who contributes regularly to Financial Planning, has written for The New York Times, Money and Kiplinger's.



John Pomeroy

Franklin Federal Intermediate-Term Tax-Exempt Income

Age: 50

Credentials: B.S., finance, San Francisco State University; MBA, University of San Francisco

Experience: Senior vice president, Franklin Templeton Fixed Income Group (1986-present); portfolio manager, Franklin Federal Intermediate Tax-Free Income (1992-present).

Ticker: FKITX

Fund inception: Sept. 21, 1992

Style: Municipal National Intermediate

AUM: $3 billion

Three-year performance as of Feb. 28, 2012: 7.8%

Five-year performance as of Feb. 28, 2012: 5.3%

Expense ratio: 0.66%

Front load: 2.25%

Minimum investment: $1,000

Alpha: -0.48 vs. Barclays Capital Municipal Total Return Index

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