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Record Fund Exodus Propels Biggest Surge in Trading: Muni Credit

A historic exodus from municipal mutual funds is propelling the biggest jump in trading in local debt since 2011 as individuals and money managers bet an expanding economy will drive up interest rates.

Individuals yanked $52 billion from the funds in the first 11 months of 2013, the most since at least 1992, when Lipper US Fund Flows data begin. The withdrawals accelerated starting in May on speculation the Federal Reserve will curb its monthly bond purchases. Outflows through year-end would extend the worst losses in the $3.7 trillion municipal market since 2008.

With AAA yields almost doubling in the past year, trading surged 23 percent last quarter from a year earlier, the most in at least two years, Municipal Securities Rulemaking Board data show. The higher interest rates are luring buyers, helping offset the fund sales and generating even more trading, said Jamie Pagliocco at Fidelity Investments and Chris Alwine, head of munis at Valley Forge, Pennsylvania-based Vanguard Group Inc., which oversees about $125 billion in local debt.

“Outflows have still been negative, and that’s going to continue to drive trading volume,” said Pagliocco, who oversees $28 billion of munis as Fidelity’s director of bond managers in Merrimack, New Hampshire. “As you see some stabilization in rates, you’ll see even more interest.”

Reversing Trend

The 2.93 million trades in the quarter through September were the most since the first three months of 2011, according to the MSRB. That was when individuals pulled money from munis after banking analyst Meredith Whitney in December 2010 incorrectly predicted a wave of local-government defaults in the following 12 months.

The elevated trading is a reversal from 2012. Transactions last year sank by 700,000 to 9.7 million, the least since 2007, as yields set generational lows. With individuals pouring $46 billion into local-debt funds in 2012, money managers were less willing to part with bonds.

State and local bonds trade less frequently than their federal and corporate counterparts because individuals own about 70 percent of munis either directly or through mutual funds, Fed data show. Those buyers typically hold to maturity. About a third of muni trades occur within a month of issuance when measuring by dollar amount, according to the MSRB.

The trend in munis was counter to that in the corporate market, where trade sizes last quarter shrank to the smallest in a year, a sign of dealers pulling back.

Risk Adjustment

The three-month stretch included Detroit’s record municipal bankruptcy filing in July. Speculation also mounted that Puerto Rico’s shrinking economy would make it harder for the commonwealth to repay bondholders, pushing the yield penalty on some island obligations to record highs.

“We’ve had a lot of credit issues in 2013, notably Detroit and Puerto Rico, and that could be causing people to increase their activity as they readjust portfolios,” said Gary Pollack, who oversees $6 billion of munis as managing director in Deutsche Bank AG’s private-wealth unit in New York.

Declines in Detroit and Puerto Rico securities followed Fed Chairman Ben S. Bernanke’s June comments that the central bank would slow bond-buying this year. That caused holders such as mutual funds to offer about $2 billion of munis for sale in a single day that month, the most since Bloomberg data begin in 1996.

Interest Kindled

Bernanke unexpectedly refrained from tapering in September. The central bank probably won’t curb bond purchases until March, according to the median of 32 economist estimates in a Nov. 8 Bloomberg survey.

The yield levels have kindled interest from Loews Corp. (L) Chief Executive Officer James Tisch said last month he saw “one of those rare opportunities where munis are so attractive” because of withdrawals from mutual funds.

The increased trading may indicate brokers and dealers boosted muni holdings from $19 billion as of June 30. That was the least since 2002 and marked a 39 percent quarterly drop, according to Fed data. The decline was the steepest since 1986 for the market’s middlemen, who typically provide a buyer base during times of stress.

“There’s more of a comfort that there are two-way flows in the marketplace,” said John Dillon, head of muni strategy at Morgan Stanley Wealth Management in Purchase, New York.

“There’s still some rate risk ahead of us, but a lot of it has been worked into the picture,” Dillon said. Because of the increased buying and selling, “the risk of a free fall is much lower than what it was a number of months ago,” he said.

Market Week

Issuers including the New York State Thruway Authority and California’s Foothill/Eastern Transportation Corridor Agency are offering long-term debt next week, bringing the total nationwide to $10 billion, the most since April, data compiled by Bloomberg show. They’re issuing with benchmark yields at the highest since September.

The interest rate on AAA 10-year munis is 2.91 percent, compared with 2.87 percent on similar-maturity Treasuries.

The ratio of the yields, a gauge of relative value, is about 101 percent. It compares with an average of 94 percent since 2001. The greater the number, the cheaper munis are compared with federal securities.

To contact the reporters on this story: Brian Chappatta in New York at bchappatta1@bloomberg.net; Priya Anand in New York

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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