Tax-Exempt Funds Gain for Third Week

Amid increased demand and liquidity in the short-term market, inflows kept tax-exempt money market funds in positive territory for a third week in a row, gaining $7 billion in new cash for the week ending Oct. 20, according to the Money Fund Report, a service of iMoneyNet.com.

The 533 tax-exempt and municipal funds in the report ended the week with total assets of $497.86 billion, compared with last week when the same amount of funds gained $6.12 billion, bringing total assets to $490.86 billion, according to the report. The average, seven-day yield for the funds dropped to 2.54% from 3.36% last week, which was down from a recent high of 5.02% for the week ending Sept. 29. The average maturity declined to 30 days from 32.

Despite the drop in rates, there is a lot of money pouring into tax-exempt money funds - especially with investors fleeing the stock market prior to Wednesday's muni rally, noted a tax-exempt money market fund manager in California.

"Crossover buyers are going into tax-exempt money funds based on after-tax rates that look attractive compared to taxable funds," he said.

California money funds, on the other hand, experienced some outflows this week as retail investors liquidate cash to pay for last week's $5 billion California revenue anticipation note deal, the manager said.

"This week seems to feel a little better," said Pam Tynan, a principal and head of short-term investments at Vanguard Group in Valley Forge, Pa. "Liquidity seems to have returned somewhat, demand has picked up, and inventories are lighter."

At Vanguard, neither inflows or outflows are a concern for the firm's tax-exempt money market funds, according to Tynan. "We are seeing nothing unusual in terms of activity," she said. "In general, the market has ample cash."

The renewed demand was evident this week with the drop in short-term yields on new issues, following the success of the California Ran sale, Tynan said.

This week, for instance, the $300 million Wake County, N.C., general obligation bond anticipate note sale on Wednesday was repriced by Banc of America Securities LLC with a 31/2% coupon to yield 1.70% from a 1.79% due to strong demand.

With the decline in short-term rates since two weeks ago , more deals are trickling back into the new-issue market, compared to recent weeks when issuers postponed deals due to historically high rates north of 2%, Tynan noted.

The Wake County deal, which has the highest short-term ratings from all three rating agencies, was sought after by money market managers who are looking for high-quality, unenhanced paper, she said.

"Funds have been looking for quality and trying to get away from lower-quality paper and enhancers who are unsure of what their end result will be down the road," Tynan explained. She was referring to the recent financial bailouts in the banking industry involving liquidity providers Dexia Group and Depfa Bank PLC.

"There is a shrinking pool of high-quality guarantors, which means a shrinking number of acceptable credits for money funds," the California manager said.

Going forward, Tynan said money market fund managers will be monitoring "event risk," stemming from the overall recession and possible further deterioration among monoline bond insurers.

"More long-term you are going to see a decline in the overall fiscal health of municipalities that could mean potential downgrades," she said. "They need to issue to raise funding to cover budget gaps, but there could be lower coverage rates on the issuance that might come to the short-term market."

The gradual drop in the Securities Industry and Financial Markets Association weekly swap index continues to be an indicator of the strong demand, market participants noted. Last week, for instance, the SIFMA index dropped to 3.45% from 4.82% after ending at 5.74% the prior week and a recent high of 7.96% on Sept. 24, according to Municipal Market Data.

In addition, the yield on daily general market variable-rate demand obligations retracted to 1.56% as of yesterday, compared with 2.02% last Thursday, according to MMD. The yield on weekly general market variable-rate demand obligations fell substantially to 2.93% yesterday versus 3.93% last Thursday.

Meanwhile, the ratio between 30-day tax-exempt and taxable commercial paper remains attractive at 69.2% as of yesterday, versus 62.3% last Friday, according to MMD.

Elsewhere in the money fund industry, inflows were positive, but much lighter than the previous week.

The 1,285 taxable funds in the report this week accumulated $19.45 billion to end the week of Oct. 21 with $2.97 trillion in total assets - a stark comparison to last week when the funds gained $52.27 billion to end the week with $2.95 trillion in total assets. The average, seven-day yield for taxable funds dropped two basis points to 1.45%.

Overall, money market funds added $26.46 billion for the week - less than half of last week's inflows - to end the week with total assets of $3.472 trillion. Last week, by comparison, all money market funds combined gained $58.38 billion to end the week with $3.446 trillion in assets, according to the report.

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