Dumb Money Flows Out of Munis, Time to Buy In?

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It is a classic case of retail investors piling into an asset class, many late to the party in chasing performance, and then bailing in a panic on the inevitable sell-off. This time it was municipal bond funds. The Wall Street Journal reports on the latest fund flow data in Friday's article, "Muni Tumult Ends a Fund-Inflow Streak":

Investors pulled an estimated $4.78 billion out of municipal-bond mutual funds last week, according to the Investment Company Institute, as oversupply and other concerns shook the muni market.
That figure represents the the biggest estimated withdrawal since the fund industry trade association began tracking weekly muni-fund outflows in January 2007. The second greatest estimated outflow was $4.2 billion in October 2008 during the heat of the financial crisis.
The outflow for the week ended Nov. 17 ends a roughly three-month run of inflows into long-term U.S. mutual funds and comes amid a weeks-long slump in muni-bond prices, triggered by a surge in issuance ahead of uncertainty about the extension of a popular federal program that provides subsidies for taxable bonds issued by state and local governments. That spike in issuance caused yields, which move inversely to a bond's price, to surge.

"When you see falling bond prices and falling bond-fund returns, it's not unusual to see some outflows from bond funds," says Brian Reid, chief economist of the ICI. A drop in the prices of the muni bonds held by mutual funds decreases the overall returns the funds pay their investors, causing some investors to cash out.

The estimated $4.78 billion withdrawn represents 1% of total muni-bond fund assets, Mr. Reid says. Retail, or individual, investors hold an estimated two-thirds of outstanding bonds in the $2.8 trillion muni market, through individual accounts and mutual funds. The rest is held by large institutional investors.

The price volatility in the muni market was compounded by the effects of the Federal Reserve's bond-buying efforts, which have driven the yields on 30-year Treasurys higher. Rates on long-term municipal debt generally move in sync with long-term U.S. Treasurys.
Also, some individual investors have been spooked by news of the fiscal strain facing states and cities that issue the bonds, says Guy Davidson, who oversees about $30 billion in muni bonds at AllianceBernstein. The magnitude of the outflows "just speaks to how nervous people are," he says.
Retail is doing what retail always does," says Hugh McGuirk, head of T. Rowe Price's muni-bond team. "Once you get a little price movement in one direction, retail [investors] tend to chase performance or move out of the funds that are going down."...Muni-bond prices began to recover slightly late last week.
Lipper FMI, a unit of Thomson Reuters that also tracks muni-bond mutual funds, on Wednesday reported that the funds lost an estimated $2.3 billion for the week ended Nov. 24. That comes on the heels of last week's record amount of money withdrawn—$3.1 billion, the largest weekly outflow since the firm began tracking the data in 1992. It followed 19 consecutive weeks of inflows averaging $535 million. Muni-bond prices began to recover slightly late last week, stanching the outflows slightly, says Tom Roseen, a senior analyst at Lipper. "It might have lessened, but it's still huge," he says.

An article in The Financial Times last week notes how much retail flows impact the muni market:

A sudden change in the behaviour of investors in a corner of the US bond markets could have far wider repercussions – for everything from junk-rated debt to blue-chip corporate borrowers.

For the first time in nearly two years, investors have pulled substantial sums of money out of US municipal bonds, a move that has already led to cash-strapped states, cities and other public bodies paying higher interest rates.

As the main buyers of municipal debt, the move by individual investors to withdraw $3.1bn from mutual and exchange-traded funds specialising in the debt sold by local governments and municipalities around the US had an immediate impact. Yields on municipal bonds, which move inversely to prices and represent the borrowing cost for issuers, shot up.

Behind the change in investor behaviour are concerns about the Federal Reserve’s huge asset-buying programme.

Yet even if the outflows stop – Lipper, the fund tracker, will release new data late on Wednesday – the fact that so many investors have pulled out of the market at the first sign of losses has potential ramifications for all debt markets.

The behaviour of individual investors, in particular, matters. The amount of money they have poured into bonds – from top-rated blue-chip corporate debt to riskier junk bonds – has been at all-time highs.

Any herd behaviour by those investors could therefore determine how quickly markets sell off when prices start to fall.

“The recent moves in municipal yields could be a potential harbinger of things to come in other bond markets,” says Greg Peters, global head of fixed income and economic research at Morgan Stanley.

“Retail got out very quickly, and because retail investors have put so much money in all types of bonds in the past 18 months, these markets are more sensitive to retail behaviour than ever before.

Retail investors, wealthy savers who put money in mutual funds, have invested nearly $670bn in bond funds since the start of 2008, Morgan Stanley says. At the same time, just over $290bn has been taken out of equity funds as investors have lost their appetite for the volatility of equity investments and, in some cases, lost faith in the earning power of stocks after a decade of losses.

The fact that most of the bonds are held via mutual funds makes them more sensitive to price moves, even though part of their appeal to investors is the relative “safety” of bonds. If investors own bonds directly, then they are paid interest and only lose money if the issuer defaults. But the value of shares in a mutual fund depends on the prices of bonds. If prices of the bonds owned by the fund fall – or bond yields rise – then the value of the fund falls too.

“It [municipal outflows] was like any negative feedback loop: the selling causes a negative trail where mutual funds have to sell bonds, which causes loss, which causes more selling,” says Tom Metzold, a portfolio manager at Eaton Vance, which has about 16 per cent of its assets in municipal bonds.

Marilyn Cohen, the founder of Envision Capital Management, which manages fixed income portfolios for individuals, says many investors had made gains on municipal bonds and were not used to seeing their online accounts down.

“A lot of these are first-time investors who capitulated in the stock market. At the first sign of bad news, many said they were getting out,” she says.

As the money flows out, some savvy investors may already be sniffing around for values. Certainly in the short end of the yield curve things may already be somewhat attractive. Looking at the short-term muni ETF (NYSEARCA:MUB) in comparison to the equivalent Treasury bonds, one finds that the yield on the muni (3.70%) has crept over that of the equivalent Treasury bond ETF (NYSEARCA:IEF) (3.62%) for the first time since the muni ETF started trading.

For an investor in the top tax bracket that would be a taxable equivalent yield of 5.72%, quite a nice cushion against possible movements in interest rates in this duration. For a buy and hold investor this could be an attractive level to buy in. Even if rates go higher and there are some declines in price, the total return would still likely look quite attractive relative to Treasuries. In fact, an article in Barron's recommended buying MUB, some bond funds and certain individual bonds.

The FT warns of a spillover into US corporate and junk bonds, yet I think (as described in another of today's posts) the risk is more likely in interenational bonds.

On the other hand, The Economist report on bonds cites Richard Bookstaber, an analyst whom I respect greatly, who has another view:

Bears are rubbing their paws. Mr Fabian has seen an uptick in inquiries from hedge funds looking to profit from a muni crash. They hope the widely held view that muni defaults are unlikely will be proved as big a misconception as the notion that house prices never fall. Rick Bookstaber, an adviser to the Securities and Exchange Commission on risk, sees uncomfortable parallels between munis and mortgage-backed markets, including opacity, over-reliance on ratings and leverage (since amassing future obligations to public employees to pay them less today is a form of borrowing). Thousands of state and local entities should pray the comparison ends there.

Disclosure: No position

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