Muni-bond funds show signs of improvement

The worst may be over for municipal-bond funds.

After experiencing $49.3 billion in outflows over 29 consecutive weeks since November, tax-free funds finally have stanched — or at least slowed — the bleeding. In fact, for the one-week period ended June 8, such funds eked out $274 million in net inflows, according to Lipper Inc.

Although muni funds experienced $172 million in net outflows during the seven-day period ended June 15, analysts remain convinced that a turnaround for the funds may be in the making.

That is because muni funds, on average, posted their 11th straight week of positive returns last week, with a gain of 0.02%, according to Lipper; over the 11-week period, they were up 3.96%.

Muni-fund accounts hold about $475 billion in assets.

ISSUANCE UP, TOO

The improved performance coincides with a marked pickup in bond issuance, a sign that issuers, too, might be returning to the market.

Utah last week sold $635 million of general-obligation debt, its first offering since its record $1.25 billion of Build America Bonds and tax-exempts in September.

Individual bond buyers “have been net purchasers for some time now,” said John Miller, chief investment officer at Nuveen Asset Management LLC.

However, buyers have favored higher-rated bonds of shorter maturities, he said, indicating some lingering nervousness.

Investors, fears stoked by state budget deficits and underfunded pensions, began fleeing muni funds late last year. Their anxiety was made worse by banking analyst Meredith Whitney’s apocalyptic forecast in December that hundreds of billions in muni issues would default.

Indeed, the S&P National AMT-Free Municipal Bond Index plunged 4.62% during the fourth quarter last year. Although mild by equities’ standards, the bond index’s drop represented a veritable free fall for muni funds, which investors generally have come to rely upon as a safe haven from volatility.

But now investors’ nerves finally appear to have calmed.

“Unless there’s a further shock, I would expect [positive flows] to continue,” said Kevin McDevitt, a mutual fund analyst at Morningstar Inc.

“We wouldn’t be surprised to see more inflows” into muni-bond funds, said Ashton Goodfield, a portfolio manager and head of muni-bond trading at DWS Investments.

Matt Buscone, a portfolio manager at Breckinridge Capital Advisors Inc., which runs $14 billion in tax-free separate accounts, agrees.

“Everyone overreacted to the [negative muni] credit story and the worry over the waves of bankruptcies and defaults,” he said. “That storm has passed a bit.”

Since October, 60 issuers have defaulted on $1.2 billion in bonds, said Christopher Ryon, co-portfolio manager of the Thornburg Municipal Bond Fund.

“That’s a default rate of 0.04%, right in line with [historic averages],” he said, rather than the 6% or 7% default rate that Ms. Whitney seemed to suggest.

Meanwhile, revenue at the state level has been picking up as states and municipalities have cut spending, helping to improve the budget picture for tax-free issuers, analysts said.

Through the first quarter of this year, tax receipts were up at the state level for five quarters in a row, Mr. Miller said.

Over the past two years, state and local head count has fallen by 2.3% while population has increased by 1.7%, said Matt Fabian, a senior analyst at Municipal Market Advisors Inc.

“So spending per person is falling rapidly,” he said.

Although the focus has been on budget woes in California and Illinois, other states have made progress.

“New York is one of the best examples of improvement,” passing a balanced budget and getting it done early, Mr. Miller said.

STATES’ SITUATION IMPROVES

“Other states that are well-disciplined, but flying under the radar are Georgia, Florida, Utah and Texas,” he said. “These are highly rated states that have pretty good pension-funding” situations.

And even California and Illinois have taken some steps to improve their fiscal situations, Mr. Miller added.

Michigan and Rhode Island have passed laws to give governors more control over weak localities, Mr. Fabian said.

“That greatly improves states’ abilities to intervene” and solve budget issues, as well as keep local politicians under the gun, he said.

Even so, few are willing to say that the muni market is out of the woods.

“We don’t know for sure if this is the flip,” where flows will finally remain positive, said Matthew Lemieux, a Lipper research analyst.

Many of the 29 consecutive losing weeks up to this month were close to being positive, he said, so a few weeks of positive flows may not mark the end of the pattern.

Mr. McDevitt noted, however, that the bloodletting has slowed since the peak outflows last December, and that positive flows are part of the five-month trend of lower losses.

In addition, investors remain risk-averse, as evidenced by continued outflows in some longer-maturity funds and single-state portfolios.

“Investors are not taking on long-term interest rate risk [and] want to be more diversified,” Mr. McDevitt said.

“I definitely think there will be more flows into broader muni [funds] where managers can pick and choose bonds, rather than be dedicated to a single state,” Mr. Lemieux said.

And states aren’t over their fiscal problems. Many have issues with underfunded pensions and increasing Medicaid burdens.

In addition, most market participants are expecting interest rates to rise and bond maturities to shorten — maybe too much, Mr. Ryon said.

“We’ve been telling clients not only to be diversified in credits but also along the yield curve,” he said.

The curve is “the steepest it’s been in 25 years,” which could give longer-term bonds more downside cushion than shorter maturities when the Federal Reserve raises short-term rates, Mr. Ryon said.

E-mail Dan Jamieson at [email protected].

Related Topics: Investment Company Institute (ICI)