Most Withdrawals of ’13 Ignore History of July Gain: Muni Credit

Mutual-fund investors pulling the most funds since December from the $3.7 trillion municipal market are creating an opportunity for buyers of individual local bonds as tax-exempt yields reach a 15-month high.

Municipal funds saw $1.5 billion of withdrawals last week, the largest outflow of 2013, Lipper US Fund Flows data show. Speculation the Federal Reserve will reduce its bond buying has pushed 10-year muni yields to the highest since March 2012. Yet sellers are ignoring more than two decades of history. Munis have gained in 21 of the last 24 years in July, Bank of America Merrill Lynch data show.

The higher yields are attractive for direct buyers of tax-exempt debt, who purchase through brokers rather than funds and control almost 45 percent of the market, said Ed Reinoso, chief executive officer of Castleton Partners. Such investors tend to hold until maturity for the tax-exempt income and are less focused on price swings, he said.

“If you buy bonds directly, you’re little affected by all of this,” said New York-based Reinoso, who manages $250 million of fixed-income for individuals. “At the very least, it’s a good time to hedge.”

Payment Wave

Muni investors in June, July and August are set to get $128 billion of principal and coupon payments, $16 billion more than the same period last year, according to Bank of America. In May, munis lost 1.3 percent, the most since December, when the local-debt market fell on speculation lawmakers were about to limit the tax exemption on municipal debt.

This time around, the drop in tax-free funds’ net-asset values is spurring withdrawals, Reinoso said. In contrast, holders of individual bonds tend to stay the course, he said.

Households are the biggest buyers of munis, holding $1.66 trillion as of March 31, Federal Reserve data show. Direct individual buyers added $1 billion to their holdings in the year’s first three months, the first quarterly increase in two years. Mutual funds are the second-largest holders, with a record $644 billion.

Yields on state and city debt climbed the past five weeks, the longest stretch since April 2011, following a jump in Treasury yields. Yields on top-rated munis due in 10 years rose to 2.21 percent yesterday, up from about 1.7 percent in early May, data compiled by Bloomberg show.

Discount Distress

As yields climbed, the $3.6 billion iShares S&P National AMT-Free Municipal Bond Fund, the largest exchange-traded fund tracking munis, sold last week at about 1.4 percent below its net asset value. That’s the biggest discount in almost two years, Bloomberg data show. Its price touched $106.70 yesterday, the lowest since December 2011, before rebounding to $107.56.

The higher tax-exempt yields will attract individuals, analysts led by George Friedlander, chief muni strategist at Citigroup Inc. in New York, wrote in a June 7 report.

Yields on some bonds “may almost be at the level where substantial amounts of cash could begin to be put to work,” Friedlander said in the report.

Investors will also have more cash to reinvest than available supply. Principal and interest payments that bondholders are set to receive in June, July and August will surpass issuance by about $40 billion, according to Citigroup.

Rutgers Leads

Localities, led by a borrowing from New Jersey’s Rutgers University set to price this week, have scheduled $9.2 billion of long-term debt offerings in the next 30 days, the most in three weeks, Bloomberg data show.

The supply may push yields above those on U.S. debt, said Chris Mauro, head of muni strategy at RBC Capital Markets LLC in New York. Yields on benchmark 10-year munis have exceeded those on corresponding Treasuries on all but one day since May. The ratio of the yields is about 101 percent. The higher the figure, the cheaper munis are in comparison. The ratio has averaged about 92 percent since 2001.

“As we continue to back up here, there’s no question that even compared to stocks, munis will start to become an attractive alternative again,” Mauro said.

For investors in the highest tax bracket, 39.6 percent, the benchmark 10-year muni yield equals 3.66 percent on a taxable basis. That compares with a 2.09 percent dividend yield for the Standard & Poor’s 500 Index of shares, Bloomberg data show. Ten-year Treasuries yield about 2.2 percent.

Tax-exempts are proving a safer destination amid the selloff than other fixed-income areas. While tax-exempts have lost about 0.4 percent this year, federal and corporate bonds have lost about 1.5 percent.

Tax-exempts are “a core part of people’s investment portfolio,” Mauro said. With the redemption wave, “there’s no question that a portion of that money is going to make its way back into munis.”

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