‘Dumb Money’ Flees Muni Funds as Investors Buy Single Bonds
John Hirsch, 57, has been buying municipal bonds during the past four months, taking advantage of falling prices as muni mutual funds are forced to sell them to cover withdrawals.
“I have no interest in trading bonds,” said Hirsch, a consultant to the medical industry in Clermont, Florida. “I’m going to hold until maturity, and at maturity I’ll get the face value back.”
Investors have withdrawn about $47 billion from U.S. municipal-bond mutual funds since Nov. 10, pulling money for 24 weeks straight, according to Lipper US Fund Flows, a Denver-based research company. Retail investors purchased about $3 billion more in individual municipal bonds in the first quarter this year than in the same period last year, according to data on trades of $100,000 or less from the Municipal Securities Rulemaking Board, which regulates muni dealers.
Surging investor withdrawals force mutual-fund managers to sell in a falling market. Investment-grade muni bond prices have dropped 4.6 percent in the six months through April, as measured by the Bank of America Merrill Lynch Municipal Master Index.
“The people who are redeeming are the dumb money, because they’re redeeming into a market where prices are down,” said Alexandra Lebenthal, chief executive officer of New York-based Lebenthal & Co., which manages about $170 million in municipal-bond separately managed accounts. Her firm has received about $30 million in new money since December.
American households own $1.1 trillion of municipal debt, or about 37 percent of the market, and represent the largest holders, according to U.S. Federal Reserve data.
In December, Meredith Whitney, the bank analyst who correctly predicted Citigroup Inc. (C)’s 2008 dividend cut, said on CBS Corp. (CBS)’s “60 Minutes” there would be 50 to 100 “sizable” municipal-bond defaults.
Since July 2009 there have been 284 defaults on municipal bonds, representing about $8.9 billion of issuance or about 0.3 percent of the $2.9 trillion market, according to data from the Fed and Municipal Market Advisors, a research firm. Investment-grade municipal bonds had a cumulative 10-year default rate of 0.06 percent from 1970 to 2009, according to New York-based Moody’s Investors Service. (MCO)
Since Whitney’s comments, “the mutual funds and the bond ETFs have taken it on the chin,” said Robert Kane, speaking about investor redemptions. “When there’s an issue in the marketplace which causes retail investors concern, they kind of run for cover,” said Kane, who’s chief executive officer of BondView.com, which provides bond portfolio analysis for individual investors.
Investors sold all categories of municipal-bond funds, which range from single-state bond funds to funds that mainly invest in short- or long-term securities, in the five months through March, according to Morningstar Inc. (MORN), a Chicago-based research firm.
“Investors have been pretty indiscriminate about what they’ve been selling,” said Miriam Sjoblom, a bond-fund analyst for Morningstar.
Outflows have been greatest among high-yield municipal funds, where investors withdrew 11 percent of their assets, and among funds that invest in long-term bonds, where investors took out 8.1 percent. Outflows have been lowest among funds that invest in short-term investment-grade municipal bonds, where investors have withdrawn 5.3 percent.
“Those who are sellers in some part are reacting to newspaper headlines and thinking, ‘Well, I’d better take some money off the table because the risks are elevated,’” said Josh Gonze, who helps oversee about $6.5 billion in municipal-bond assets as co-portfolio manager of six mutual funds for Santa Fe, New Mexico-based Thornburg Investment Management Inc.
Buyers of individual bonds through discount brokers have been “aggressively” accumulating issues in the last few months, said Chris Shayne, senior market strategist for Mill Valley, California-based BondDesk Group, a bond marketplace that works with dealers, financial advisers and discount brokers including New York-based E*Trade Financial Corp. (ETFC) Individual investors cannot purchase bonds directly with BondDesk.
The ratio of buy orders to sell orders, a measure of investor demand, from do-it-yourself investors jumped to about 6 in February from 3.6 in November, according to data from BondDesk, which has about 30 percent of municipal-bond market transactions.
Waiting for Yield
Investors with TD Ameritrade Holding Corp. (AMTD) brokerage accounts purchased 22 percent more individual municipal bonds in the first quarter of 2011 than they did the year before, according to Perry Guarracino, director of fixed income for the Omaha, Nebraska-based company.
“They know what they’re looking for, and waiting for certain yield levels” before buying, said Guarracino, who’s based in Jersey City, New Jersey.
Advisers and brokers have been buying bonds less aggressively for their clients, BondDesk’s Shayne said. The ratio of buy to sell orders for financial advisers and brokers purchasing bonds on behalf of individual investors has stayed at about 3 during the same period, the data show.
Individual investors purchasing bonds directly have been primarily buying short-term bonds, said W. David Hemingway, chairman of Zions Direct, an online brokerage that runs municipal-bond auctions open to individual investors.
“It’s hard to sell something longer than about three years,” Hemingway said. Zions Direct is a unit of Salt Lake City-based Zions Bancorporation. (ZION)
That’s because individuals are concerned about rising interest rates, which typically cause longer maturity bonds to fall more in price than shorter dated debt, said Michael Zezas, municipal strategist for New York-based Morgan Stanley. (MS)
“Investors don’t know what to make of the rate environment,” Zezas said.
Interest payments on municipal bonds generally are exempt from federal taxes as well as state taxes for investors who reside in the issuing state.
In April, Senators Ron Wyden, a Democrat from Oregon, and Dan Coats, an Indiana Republican, introduced a bill that would eliminate the tax-exemption on municipal bond interest and replace it with a tax credit. The bill is awaiting further action with the Senate Finance Committee. In December, President Barack Obama’s deficit-reduction commission also proposed to end the exemption.
Municipal bonds have returned 2.2 percent year to date according to the Bank of America Merrill Lynch Municipal Master Index, which yielded 3.9 percent on April 30, equivalent to a taxable yield of 5.9 percent for an investor in the top 35 percent federal tax bracket.
Hirsch said he likes the steady income he receives from his municipal bonds, which account for about 20 percent of his portfolio.
“What I’m interested in is at a bare minimum preserving capital, and a predictable return,” he said.
Mutual funds may provide investors with better diversification than they can get building a portfolio of bonds on their own, and may be more cost-effective, said Morningstar’s Sjoblom.
“There’s no transparency as far as trading costs go when you have a broker buying or selling bonds. You don’t know if you’re getting a good deal or not, and usually you’re not,” she said. Sjoblom said investors should consider mutual funds from Fidelity Investments including Fidelity Municipal Income (FHIGX), which primarily holds investment-grade municipal bonds and has an average maturity of 11 years.
Mutual-fund investors may experience more volatility than holders of individual bonds since mutual funds must price their portfolios to market every day, said David Kotok, chief investment officer of Sarasota, Florida-based Cumberland Advisors, which manages about $1.5 billion.
Greg Serbe, a municipal-bond portfolio manager for Lebenthal & Co., recently invested about $1 million in New York State Dormitory Authority bonds rated AA- by Standard & Poor’s that mature in 2018 and pay a 5 percent coupon. He said that such high-rated short- and intermediate-term bonds have been hard to find.
“New issuance has fallen off the face of the earth,” said B. Craig Elder, a fixed-income senior analyst for Milwaukee-based Robert W. Baird & Co. Private Wealth Management, which manages almost $63 billion. Elder said he has been purchasing general-obligation bonds from AAA rated states such as Missouri for Baird’s clients.
About $45 billion in municipal securities were issued in the first three months of 2011, compared with about $87 billion in the first quarter of 2010, according to Thomas Doe, chief executive officer at Concord, Massachusetts-based Municipal Market Advisors.
Fred Bacani said he has been purchasing pre-refunded municipal bonds, whose coupons and principal payments are backed by U.S. Treasury bonds held in escrow, for higher pretax yields than Treasury bonds of similar maturities. Bacani is head of fixed-income trading for Newtown Square, Pennsylvania-based Veritable, which manages about $10 billion and whose clients have $20 million or more to invest.
“I don’t really know how to evaluate the credit” of a general-obligation bond issued by the state of California, because “it’s sort of a political question,” said Los Angeles-based Thomas, who oversees $7.4 billion on behalf of investors with $5 million or more in assets.
He recently invested $1 million in Ocean Shores, Washington, local improvement district bonds rated BBB+ by Standard & Poor’s that mature in 2031, at a pretax yield of 7.3 percent.
Investors who prefer to lock in a rate of return should consider holding bonds individually, BondView.com’s Kane said.
“My mother-in-law, Florence, in Long Island, she holds them for 10 or 20 years and doesn’t really care what happens in the ups and downs in the market,” Kane said.
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