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The Muni-Bond Technical Tango

Simmering credit worries are no match for muni investors' yield grab.

Municipal bankruptcies are hitting the headlines again, and much of the recent action is coming out of the Golden State. Stockton, Calif., filed for Chapter 9 bankruptcy protection on June 29, 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.

A muni-market bankruptcy trifecta is a rare thing, and this news would have caused plenty of hand-wringing in late 2010, when bonds were selling off and default paranoia reached a fever pitch. But muni investors are shrugging it off this time around. In fact, they've gotten more comfortable with risk as the year has progressed, even as muni-bond yields have continued to grind lower. High-yield muni funds in particular have been in vogue lately, taking in nearly $4 billion during the past three months alone.

It's not hard to see what's driving investor interest. The Federal Reserve's actions since the financial crisis--the zero interest-rate policy, quantitative 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 roughly $45 billion combined over the past 12 months. Reinforcing this behavior, risk-taking has paid off for muni investors lately. The typical high-yield muni fund has already gained close to 10% for the year to date through July 31. The median national long-term muni fund, the next-best-performing muni category, is more than 3 percentage points behind.

Strong Demand Meets Scant Supply
Even though muni funds have maintained a blistering pace lately, a reversal isn't necessarily imminent, and the muni market's unique technical dynamics partly explain why. Individual investors' hunt for yield remains a key driver of flows into muni funds, for instance. When bond yields are falling, muni investors often buy funds instead of individual bonds. That's because funds, due to their mix of older bonds with higher payouts, tend to offer more attractive income streams than what an investor could buy in the market directly. 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.

But whether individuals are buying funds or purchasing bonds directly, their appetite holds particular sway in the muni market compared with taxable-bond markets. Households own half of the outstanding $3.7 trillion muni market directly and mutual funds own another 22%, according to the Federal Reserve's December 2011 Flow of Funds report.

Muted supply is another factor working in the market's favor. Although gross muni issuance has picked up from 2011's low, roughly two thirds of new supply is coming from refundings, according to some estimates, a larger portion than usual. This has contributed to negative net new issuance--meaning total redemptions from refundings and maturities have outpaced total new supply--resulting in fewer bonds available to meet demand, a condition which some analysts expect to continue in coming months. BlackRock's muni-bond group head Peter Hayes also suggests that a broader deleveraging trend among municipalities could cause the total amount of municipal bonds outstanding to decline over the next five years, as the political climate favors frugality over more spending.

What Could Go Wrong?
But have these technical dynamics made muni-fund investors too complacent? On one hand, it's understandable that investors aren't panicking over a few bad headlines this time around. Fidelity muni head Jamie Pagliocco noted that the latest wave of California bankruptcies hasn't disrupted the market partly because the size of the debt outstanding isn't too concerning. According to JPMorgan, the total debt of these three issuers adds up to just 0.15% of the California muni market and 0.03% of the national market.

Muni investors hate surprises, though, and bad news could still be a potential source of volatility. With muni yields at all-time lows, it may not take much of a shock to shake things up. For example, the broadly diversified  Vanguard Long-Term Tax Exempt's (VWLTX) SEC yield recently hit a record low of 2.2%, dropping substantially from its 4% level of early 2011. Using the fund's 6.3-year duration as a rough guide, yields would have to rise only a third of a percentage point before capital losses would eat away the fund's entire income stream.

In addition to a resurgence of headline risk, factors such as rating agency downgrades or an unexpected spike in new issuance could rattle the market. Don't underestimate the ability of a plain-old interest-rate bear market to test muni investors' resolve, either. Looking back at late 2010's sell-off and mass exodus from muni funds, most tend to pin the blame on Meredith Whitney's Dec. 19, 2010, appearance on "60 Minutes." But by the time Whitney made her doomsday prediction, muni prices were already falling and investors had started to pull their money out of muni funds. The shift occurred in November 2010, around the time U.S. Treasury yields also sold off sharply following the Federal Reserve's announcement of a second round of quantitative easing. Even a temporary spike in Treasury yields in the year ahead could snap muni investors out of their sanguine mood.

Recent fund flows could also be a contrarian indicator. After all, muni-fund investors' timing hasn't been great lately. In January 2011, investors pulled an estimated $12 billion out of muni funds when yields were at elevated levels. Going back to the Vanguard fund example, flows didn't turn modestly positive for until September of last year, but by that time, returning investors would have already missed out on two thirds of the year's gains. So far in 2012, investors have continued to sock another $34 billion into open-end muni funds after they've already had a heady run. Those jumping on the high-yield muni bandwagon in recent months especially have already missed out on a substantial amount of price appreciation.

As long as yields remain low or continue to grind lower, 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 much of 2009's rally, penalizing the more conservatively run offerings out there. Investors enticed by these records and relatively plump payouts will leave themselves vulnerable should the market turn. In a market that's priced to perfection, a muni-fund investor's best defense is a good memory.

A version of this article appeared in Morningstar Advisor Magazine.

Miriam Sjoblom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.