Catching the Wave of Municipal Bonds

"A lot of this summer's rally in bonds has to do with higher oil prices and speculation in the oil markets," says Dave Fare, co-portfolio manager of the $2.6 billion (SHMMX Quote) Smith Barney Managed Municipals fund. "Even over the last few days you have seen rates tick up as oil prices have come off their highs."

In mentioning the link between higher oil prices and interest rates, Fare is referring to a widely-held hunch on Wall Street this summer that higher oil prices will act as a brake on economic growth and prevent the Fed from aggressively raising rates. But like most muni portfolio managers, Fare rejects this idea and expects the Fed to continue its series of rate hikes. He predicts the Fed's overnight lending rate to be at 2% by November, up from its current level of 1.50%.

"It's been a very surprising summer, but we expect rates to rise," says Bill Fitzgerald, managing director of Nuveen Investments (JNC Quote). "And when that happens, muni bonds tend to outperform taxables."

Magnificent Munis

Analysts point to a favorable supply/demand dynamic as one of a number of reasons why munis are the bonds of choice in a rising rate environment. The primary reason for the positive supply/demand outlook is quite simple: a lack of foreign demand.

Unlike domestic buyers, non-U.S. investors are ineligible for the significant tax benefits. That means muni prices would hold up well in the event that investors outside America display less of an appetite for Treasuries, a scenario that has become more of a possibility as the U.S. government continues to run a massive budget deficit.

And while the government has increased the supply of Treasury bonds in order to fill the gaps, state and local governments have reduced their muni issuance so far this year, according to analysts. Mark McCray, portfolio manager for the $330 million (PFMIX Quote)PIMCO Municipal Bond fund, says he expects gross new issuance to be $300 billion in 2004, down from $380 billion in 2003.

Magnificent Munis National Municipal Bond Funds
Fund	Ticker	YTD %	Annual Returns* %			Expense Ratio %
			2003	2002	2001
Eaton Vance National Municipals	EANAX	2.32	9.1	11.0	3.5	.78
Smith Barney Managed Municipals	SHMMX	0.41	6.0	7.3	3.7	.68
PIMCO Municipal Bond	PFMIX	0.96	5.4	8.3	7.7	.49
*Annual returns through 8/25/04. Source: Morningstar