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From The No-Load Fund Investor, 10/14...
Return of Volatility
The stock market had a rough go of it in September, especially as the month came to a close. Once again, however, large U.S. stocks and the funds that invest in them had a much easier time than other types of stock investments.
For example, while the S&P 500, the leading index of large-cap U.S. stocks, dropped 1.4%, and the large-cap U.S. stock funds we track produced an average loss of 1.9%, the Russell 2000 index of small-cap stocks plummeted 6.2% and is now down 5.3% for the first three quarters of the year.
Foreign stocks fell hard, too, with a 4.1% decrease in the MSCI EAFE Index of developed foreign markets and considerably larger losses throughout the so-called emerging markets. Like U.S. small caps, most foreign equity markets are down so far this year. Broadly speaking, financially strong companies with economically resistant businesses lost the least in September, while weaker, more economically cyclical companies fell much harder. In terms of investment styles, this meant that ‘growth’ outperformed ‘value.’ In terms of sectors, natural-resources, including metals and energy, dropped the most. In fact, on average, the natural resources funds we track plummeted 11.8%. Meanwhile, healthcare stocks continued their comparative strength; on average, the healthcare funds we track lost only 1.1%.
The typical investor in municipal bonds or bond funds has profited handsomely so far this year. For example, the average total return of the funds in Morningstar’s Municipal National Intermediate-Term category was 5.59%; that of the equivalent group of long-term municipal bonds was 8.88%, as falling rates have helped all kinds of high-quality, longer-term U.S. bonds.
However, though high credit quality has been a boon in the taxable U.S. bond market so far in 2014, such has not been the case in the municipal bond market. In fact, lower-quality, high-yield municipal bonds have outperformed tax-free, higher-quality fare. For instance, the funds in Morningstar’s High Yield Municipal Bond category have produced an average total return of 11.67% so far this year – the highest of any of Morningstar’s municipal bond categories.
One reason is that after poor performance in 2013, valuations within the high-yield municipal area were appealing as this year began. Huge, high-profile financial problems in Puerto Rico and Detroit (and some other major issuers of municipal bonds) caused prices to drop and yields to rise in the high-yield municipal market. In fact, the average high-yield municipal bond fund dropped 6.0% last year, vs. a loss of about half that size for the average investment-grade municipal bond fund.
Despite the rebound in the high-yield municipal sector so far this year, it offers high yields even now, relative to its investment-grade peers. Case in point: as of Sept. 29, 2014, the S&P Municipal Bond HighYield Diversified Index posted a weighted average yield of 6.43% (above 9% on an after-tax basis, assuming a high tax bracket). By contrast, the S&P National AMT-Free Municipal Bond Index had a yield to maturity of 3.06%.
High-yield bonds must yield more than investment-grade ones to compensate investors for the greater chance of default. Through July of this year, while only 0.37% of the total municipal bond market had defaulted, 2.88% of the par value of the high-yield municipal market had done so. Given the superior total return of the high-yield municipal market so far this year, the defaults have not detracted enough to fully erode the yield advantage.
The U.S. economy appears to be improving, a phenomenon which should increase tax revenue and improve the fiscal situation at the state and local level. Meanwhile, new issuance of municipal bonds has been at least 10% less than last year through this time. An improving economy, higher tax receipts and a shrinking supply of new municipal debt should continue to support prices in the municipal bond market, especially the high-yield sector, even if interest rates tick up a bit.
Four our complete analysis of high-yield municipal bonds, see the October issue of The No-Load Fund Investor.
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