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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.

As muni yields have plunged over the past year, refunding activity—issuers replacing higher coupon bonds nearing their call dates by issuing new bonds—has picked up, leaving individuals with cash to reinvest in a climate of painfully low yields. As long as that trend persists, it could support ongoing inflows to muni funds. (Unfortunately, muni funds themselves face the same problem: As their higher coupon bonds get called away, they’re forced to reinvest at current, lower rates.)

Whether through funds or direct purchases, continued demand from individual investors is one reason why a sustained rise in muni-bond yields isn’t necessarily around the corner. Demand from individuals plays a unique role in the muni-market compared with other bond sectors, because households own roughly half of the outstanding $3.7 trillion market and mutual funds own another 22%, according to the Federal Reserve’s December 2011 “Flow of Funds” report. So even with muni yields hovering near all-time lows, demand from individuals with few other options for tax-exempt income could remain strong.

Muted supply is another factor that could keep muni yields low for now. Although gross muni issuance is expected to pick up from 2011’s low of $288 billion (the norm for the past decade has been closer to $385 billion), roughly two thirds of new supply is because of refundings, according to estimates, a larger portion than usual. Many analysts expect that a rise in refunding activity could contribute to negative net new issuance in the near-term—meaning that redemptions from refundings and maturities could outpace new supply—result- ing in fewer bonds available to meet demand. BlackRock’s muni-bond group head, Peter Hayes, also suggests that a broader deleverag- ing trend among municipal issuers could cause the total amount of muni bonds outstanding to decline over the next five years, as the political climate favors frugality over more spending.

Flare-Ups Ahead
By now, most agree that the worst default predictions of 2011 were overblown, and munis have been helped by favorable supply-and- demand dynamics in the meantime. Muni investors hate surprises, though, and a number of headline risks and other market factors could shake them out of their complacency.

There’s cause for encouragement: Many state and local governments have taken steps to close budget gaps through some combination of hiking revenues and spending cuts, and several studies noted that defaults actually decreased in 2011. Despite signs of improve- ment, though, the fiscal situation remains grim for many, especially local governments. A report issued by the Pew Charitable Trusts in June noted that many local governments are reeling from the “one-two punch” of reduced state aid and falling property taxes, which make up the lion’s share of local budgets. While there are still many solid credits in this sector and most fund managers expect defaults to occur only in isolated cases, some are treading lightly in this area because of the challenging fundamental backdrop. Others, such as Fidelity’s muni-bond team, see opportunity among local government debt where their research gives them an edge.

Inadequate funding for future pension and health-care obligations remains another looming problem that must be addressed. A different June Pew report noted that states’ funding gaps for retirement benefits rose 9% in fiscal year 2010 to $1.4 trillion. The report used the states’ own actuarial assumptions for investment returns—8% on average—num- bers that have come under criticism for being too optimistic.

Still, the report acknowledged that states have undertaken an unprecedented number of reforms that at least begin to address this issue. Rather than viewing underfunded pensions and health-care obligations as an imminent threat to bond payments, most fund managers continue to monitor these situations and factor them into their overall assessment of issuers’ creditworthiness.

While poor fundamental trends don’t always directly translate into widespread defaults, even isolated credit trouble can spread to the broad muni market if it makes investors more wary.

Bad headlines could continue to come out of California, as a number of local governments remain under strain. Stockton, Calif., filed for Chapter 9 bankruptcy on June 29, for example, becoming the largest city and third largest municipality to declare bankruptcy. Small ski town Mammoth Lakes followed a week later, and the city of San Bernardino voted to file shortly after that. The dissolution of California’s redevelopment agencies, a 60-year-old program that helped finance projects to combat urban blight, has also raised concerns about the possibility of defaults on the agencies’ bonds.

Puerto Rico is another credit to watch. Its 15% unemployment rate, large unfunded pension liability, and high debt/GDP ratio are the worst around. Despite these issues, Puerto Rico’s debt is widely owned because of its triple tax-exempt status—meaning it’s exempt from city, state, and federal taxes—which makes it popular with single-state funds where yield and bond supply may be scarce.

Rating-agency downgrades are another factor that could put pressure on muni prices. Some reports suggest that the frequency of “super downgrades”—when rating agencies downgrade bonds by three or more notches at once—has been rising as the agencies face greater regulatory scrutiny and catch up to years of deteriorating fundamentals that they may have missed.

Finally, don’t underestimate the ability of a plain-old interest-rate bear market to test muni investors’ resolve. Looking back at late 2010’s sell-off and mass exodus from muni funds, most tend to pin the blame on Meredith Whitney’s December appearance on “60 Minutes.” Muni-bond prices had already been falling, however, and investors had begun pulling their money out of muni funds that November, around the time U.S. Treasury yields also sold off sharply after the Federal Reserve’s announcement of a second round of quantita- tive easing. Even a temporary spike in Treasury yields in the year ahead could snap muni investors out of their sanguine mood.

Striking a Balance
Though recent fund flows show a growing appetite for yield, in some ways, muni-fund investors on the whole have become a more cautious group than they were before the credit crisis hit. Since 2006, there’s evidence that suggests this traditionally income-focused group has become more concerned about preserving capital and limiting volatility.

For starters, single-state muni funds have been shrinking relative to their national counterparts, as some investors appear to be choosing broad diversification over the incremental tax benefits that they get from investing only in a portfolio of in-state bonds. At the end of 2006, assets in single-state muni funds accounted for 43% of the open-end muni-fund universe, a share that dropped to just 31% in 2012.

Among national funds, the long-term and high-yield muni funds used to be the most popular among muni investors because that’s where they could expect to maximize their income. These groups suffered steep price declines in 2008, though, taking many investors by surprise. That preference has shifted in recent years as more investors have allocated to short-term muni funds—partly to remedy the near-zero yields of money market funds—and intermediate-term funds. At the end of 2006, assets in long-term and high-yield muni funds took up around 56% of the national open-end universe, but that has since reversed. Short- and intermediate-term muni funds now comprise about that much.

At the fund level, there are also some signs showing fund firms that employ riskier strategies in pursuit of yield have fallen out of favor with investors, while firms with more circumspect approaches have gotten more attention. For example, T. Rowe Price’s prudently run muni stable has received a higher percentage of inflows than the muni-fund universe at large over the past three years; its growth due to inflows over this period amounts to 38% of starting assets versus muni funds’ 20% intake overall. Meanwhile, Eaton Vance has seen its share of the pie shrink, primarily because of a steady trickle of outflows from its flagship fund Eaton Vance National Municipals EANAX. The fund’s typically aggressive stance toward interest-rate risk, including using leverage through tender option bond structures, made it a category darling before 2008’s downturn demonstrated the downside of its approach. The fund’s 31% drop that year was the worst of any national long-term muni fund. Investors seem to be favoring the less risky offerings even within the go-go Oppenheimer Rochester muni-fund lineup—known for its heavy use of leverage and penchant for the market’s rockier sectors. Oppenheimer Limited Term Municipal Fund OPITX has taken in a little more than $2 billion over the past three years even as its big sibling Rochester National Muni ORNAX has seen modest outflows.

Not all of muni-fund investors’ decisions reflect a preference for caution over yield, though. Offerings from Nuveen and Lord Abbett, two yield-focused firms, have grown at a rapid clip in the past few years. (Morningstar fund analysts have a less rosy view on these funds’ prospects; we assign several of them Neutral and Negative analyst ratings.)

As long as yields remain low or continue to grind lower, muni-fund investors may be tempted to take on even more credit or interest-rate risk in order to squeeze every last drop of income out of a bone-dry market. Plus, the longer the muni market rewards risk-taking, the more likely that riskier funds’ records will start to tempt investors. For example, 2008’s historic downturn has already rolled off funds’ trailing three-year records but still include 2009’s rally, penalizing the more conservatively run offerings out there.

In a market that’s priced to perfection, and 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 is an associate director of fund analysis at Morningstar.
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