The classic strategic reasons to own municipal bonds still hold true: They generally have low correlations to other asset classes and offer a meaningful tax advantage to investors — features that we believe are unlikely to change in the near term. However, the municipal bond market has experienced a significant shift over the past several years through the virtual demise of municipal bond insurance and the stress of highly constrained federal and state budgets.

Given these structural changes, investors may be wondering whether municipal bonds continue to warrant an allocation. Contrary to overblown fears amplified in the media, we believe municipal bond investments are potentially quite attractive: Defaults have remained low; spreads are attractive on a historical basis; and muni/Treasury ratios are still above long-term averages. If we focus for a moment on spreads in the current low-default environment, it becomes clear that investors are getting paid more than average for risks that we believe are generally in line with historical levels.

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The presence of bond insurance primarily influenced the AAA credit sector, so limiting our view to AA-rated issues and below is a better measure of historical spread levels. Current spreads range from 20 basis points to over 100 basis points for securities rated AA to BBB versus their historical averages over the past 13 years.
If the volatile time period of October 2008 through December 2011 is excluded, the comparison of current spreads to a “normalized” time period (January 30, 1998, to September 30, 2008) illustrates that today’s spreads are 50 (AA) to 150 (BBB) basis points wider than would typically be expected. For this and other reasons, including stronger-than-expected credit fundamentals and high muni recovery rates, we believe this may be an attractive entry point for municipal bond investors.

One way to approach this opportunity is to use actively managed funds in place of or as a complement to individual bonds. Relying on professional managers and deep research teams to take advantage of timely opportunities provides not only the potential for additional return for investors but broader diversification and risk mitigation in a market environment that is much more challenging to navigate today than it was only ten years ago.

Read Putnam’s white paper: Evolving municipal bond market makes compelling case for active management.

Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. Capital gains, if any, are taxable for federal and, in most cases, state purposes. For some investors, investment income may be subject to the federal alternative minimum tax. Income from federally tax exempt funds may be subject to state and local taxes.