While Muni Fund Investors Flee, Others Pounce

The fiscal crisis in states and cities is a buying opportunity for John Hirsch. He's been snapping up municipal bonds since the beginning of the year, taking advantage of falling prices as muni mutual funds are forced to sell bonds to cover withdrawals. Hirsch, 57, is looking for income and isn't worried about fluctuating market values. "I have no interest in trading bonds," says Hirsch, a consultant to the medical industry in Clermont, Fla. "I'm going to hold until maturity, and at maturity I'll get the face value back."

Investors have withdrawn about $48.5 billion from U.S. municipal-bond mutual funds since Nov. 10, pulling money for 25 weeks straight, according to Lipper US Fund Flows, a research company in Denver. Those withdrawals have forced mutual fund managers to sell, putting downward pressure on prices. Investment-grade muni-bond prices have dropped 3.7 percent in the six months through May 6, as measured by the Bank of America Merrill Lynch (BAC) Municipal Master Index. That has driven yields on bonds in the index, which rise when prices fall, to 3.74 percent, which is equivalent to a taxable yield of 5.75 percent for an investor in the top 35 percent federal tax bracket. That's up from 3.46 percent on Nov. 10.

Mutual fund muni-bond investors may have been spooked by the financial difficulties facing many state and local governments. In December, Meredith Whitney, the bank analyst who correctly predicted Citigroup's (C) 2008 dividend cut, forecast 50 to 100 "sizable" municipal-bond defaults in an appearance on CBS's 60 Minutes. Since July 2009 there have been 284 defaults on about $8.9 billion of municipal bonds, or 0.3 percent of the $2.9 trillion market.

In the wake of Whitney's comments, "the mutual funds and bond ETFs have taken it on the chin," says Robert Kane, chief executive officer of BondView.com, which provides bond analysis for individuals. "When there's an issue in the marketplace which causes retail investors concern, they kind of run for cover."

At the same time that fund investors have been selling, people like Hirsch have been stepping up direct purchases. Retail investors bought 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. Lebenthal & Co. in New York, which oversees about $170 million in municipal-bond separately managed accounts, mainly for individuals, has received about $30 million in new money since December, says CEO Alexandra Lebenthal.

Buyers of individual bonds through discount brokers have been "aggressively" accumulating issues in the last few months, says Chris Shayne, senior market strategist for BondDesk Group, a bond marketplace in Mill Valley, Calif., that works with dealers, financial advisers, and discount brokers. Investors buying bonds recently are likely wealthier and have a higher risk tolerance than those who have been selling fund shares, he says: "You would have to be fairly sophisticated to have recognized this as a good buying opportunity."

Investors with TD Ameritrade (AMTD) brokerage accounts purchased 22 percent more individual muni bonds in the first quarter of 2011 than they did the year before, says Perry Guarracino, director of fixed income for the Omaha (Neb.) company. "They know what they're looking for, and waiting for certain yield levels" before buying, says Guarracino, who's based in Jersey City, N.J. American households own $1.1 trillion of municipal debt, or about 37 percent of the market, according to U.S. Federal Reserve data.

Professional investors are seeing less risk in munis, as reflected in the price of credit default swaps. An investor seeking to insure $10 million of municipal debt against default for five years would have paid $115,625 on May 2, the least since October 2009, according to the Markit MCDX index. Speculation about defaults is dwindling because buyers recognize that issuers' finances are improving, says Paul Brennan, a senior vice-president in Chicago for Nuveen Asset Management, who oversees $12 billion of municipal bonds. "The risk perception got too high, given the attention a lot of pundits received for dire predictions," he says. "Investors are starting to realize that these dire predictions are overblown."

Hirsch, the medical consultant, says 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," he says, "and a predictable return."

The bottom line: As fears of default send muni-bond investors fleeing, some less risk-averse individuals are attracted by yields approaching 4 percent.

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