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Lessons From the Muni-Bond Rebound

With potential risk flares set to fire off from multiple directions, a muni-fund investor’s best defense is a good, long memory.

Miriam Sjoblom, 08/20/2012

Is anyone out there still guarding their savings against the coming municipal-bond apocalypse?

That doesn’t look likely, judging by the volume of new cash flooding muni-bond funds over the past several months. Once the muni headline scare of late 2010 subsided, investors began dipping their toes back into the water in the spring of 2011. Later that year and into 2012, they were diving in with abandon, performing jackknifes, cannon balls, and can openers.

Since the tide turned after a record $43 billion in outflows from November 2010 through April 2011, muni-bond funds have taken in more than $36 billion. That’s more than any Morningstar taxable-bond category except for intermediate- term bond funds (which took in $77 billion).

Rewarding the Reach
Flow patterns over the past 12 months suggest that muni-fund investors also are getting more and more comfortable taking risk. At first, investors favored short- and intermediate-term muni-bond funds while continuing to pull money out of long-term funds; high-yield muni funds saw more-tepid demand. Flows into long-term funds turned positive in September 2011, though, and high-yield muni funds have been in vogue so far this year, taking in $5.5 billion through May. This behavior—investors reaching further and further out the risk spectrum in search of elusive incremental yield and reward—should please Ben Bernanke. The Federal Reserve’s actions since the financial crisis—the zero interest-rate policy, quantita- tive easing, and Operation Twist—seem designed to push returns-starved investors into riskier assets by keeping yields on “risk-free” U.S. Treasuries and other high-quality assets repressively low. That trend has played out elsewhere in the bond market, too. Both high-yield corporate and emerging-markets bond funds have taken in close to $20 billion over the past year.

Reinforcing this behavior, risk-taking lately has paid off for muni investors. In 2011, for example, funds that took more interest-rate risk generally had the highest returns. Most funds in the muni-national long category gained between 9% and 13% last year (the median fund in the category gained 10.7%), far outpacing their income streams as yields plunged; high-yield muni funds garnered similar returns. If you used leverage, all the better: The closed-end muni-national long category returned 18%. That blistering pace hasn’t showed signs of slowing, either. Muni funds have continued to tear up the turf so far in 2012, this time with lower-quality leading the charge. The high-yield muni category median shot up 6.7% in the year’s first half alone, while the long-term median followed with a 4.7% gain.

Recent returns may have defied predictions of a looming muni Armageddon, but can they continue? That looks like a long shot. Let’s use the broadly-diversified Vanguard Long-Term Tax Exempt VWLTX as a proxy for the market. The fund gained 10.7% in 2011, but only 4.4 percentage points came from its income stream. The rest came from price appreciation because of falling yields. It gained another 4.5% for the year through June, again mostly due to price appreciation. But the fund’s SEC yield recently hit an all-time low of 2.4%, dropping substantially from its 4% level in early 2011. Using the fund’s 6.3-year duration as a rough guide, yields would have to drop another full percentage point for the fund to experience price appreciation in the ballpark of 2011’s.

So if you’ve loaded up on munis in recent months hoping for more of the same, you’re likely to be disappointed. In fact, the best time to buy in recent memory would have been in January 2011, exactly when prices were falling and panicked investors were pulling large sums out of muni funds.

Technical Tango
But even for those who have more realistic return expectations, the search for yield remains a key motivation driving inflows. When bond yields are falling, muni investors often buy mutual funds instead of individual bonds. That’s because funds, with their mix of older bonds with higher payouts, tend to offer more attractive income streams than what an investor could buy directly. In a rising-yield environment, the reverse happens: Investors prefer to lock in a higher yield by purchasing bonds directly as fund payouts lag behind.

Miriam Sjoblom is an associate director of fund analysis at Morningstar.
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