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Risk Makes a Return to the Market

Cash is flooding into municipal bond mutual funds at a record pace as investors become more comfortable taking risk and spiriting money out of safe havens.

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A heartier risk appetite in financial markets has lifted a broad spectrum of asset classes.

The Standard & Poor's 500 Index, pummeled all of 2008 and the beginning of 2009, is now up 32% since March 9. A barrel of oil trades at around $58 after languishing around $40 earlier this year. A measure of volatility known as the VIX, which was as high as 56 earlier this year, has subsided to 31.

Robert Adler, president of AMG Data Services, said money is coming off the sidelines and into riskier investments.

"There's a risk-aversion that appears to be leaving the market in some of the riskier sectors," he said. "We are seeing risk entering the market."

During the throes of the financial crisis in the fourth quarter last year, cash drained from most financial markets and into safer perches like money market funds and Treasuries. That was a perilous time for the 1,728 mutual fund share classes devoted to state and local government debt.

Investors ferried $9.42 billion out of muni funds in the fourth quarter, according to AMG Data. Market losses bled an additional $42.26 billion from the sector.

The combination of outflows and market losses crunched municipal funds' assets from a high of almost $398 billion in September to less than $337 billion in December.

"People forgot munis were safe credits," said Jed McCarthy, managing member of 1861 Capital Management.

That trend reversed in 2009. Muni funds that report their figures weekly have posted a net inflow every week this year.

During the week ended May 13, the funds reported an inflow of $1.12 billion, the eighth-heaviest inflow since AMG Data started tracking fund flows in 1992.

This group excludes a number of fund families that report their figures monthly, including Vanguard, Putnam, and Fidelity. Figures that include the entire universe of muni funds show inflows demolishing previous records.

Investors are entrusting about $1.73 billion a week to muni funds, according to AMG, based on a four-week moving average.

"I think you can infer it's a sustainable trend," Adler said. "Flows tend to follow performance, so it's not surprising that the weekly inflows and the rate of flows are climbing, because investors become more encouraged as these trends continue. ... As long as performance is positive there's no reason to believe these inflows will subside."

Inflows in the sector have never been close to this.

In mid-2008, funds were posting inflows of about $1.37 billion a week. Before last year, inflows broke $1 billion on a four-week average basis only one time - briefly, in March 1993.

The torrid pace of inflows and healthy market appreciation - $23.38 billion so far this year - have pushed funds' assets back up to $386.97 billion.

In its weekly report last week, EPFR Global asserted that "risk appetite appeared to move up another notch."

The fund tracker supported this claim by pointing out the highest flows into high-yield bond funds on record and the strongest flow into U.S. equities this year.

For its part, the $36.23 billion high-yield muni fund sector is attracting $162.7 million from investors a week, according to AMG.

Funds dedicated to the commodities, financial, energy, and real estate sectors are attracting cash from investors, EPFR reported. It said municipal funds were the beneficiaries of about 45% of bond fund inflows for the week.

Investments in riskier mutual funds coincide with a drainage of cash from money market funds, which as safe havens often yield well below 1%. The $3.7 trillion sector reported outflows of $35.5 billion in February, $51.15 billion in March, $18.7 billion in April, and $15.2 billion so far in May, according to AMG.

Investors' newly acquired taste for risk is battering the world's premier safe haven - U.S. Treasuries. The yield on the 10-year Treasury has swelled 100 basis points in the last five months.

Meanwhile, in the same period, the yield on triple-A 10-year munis has tumbled almost 120 basis points, according to Municipal Market Data.

Eric Friedland, director of municipal research at Belle Haven Investments, said more people are recognizing that munis offer stable returns with little risk and volatility. He said he has been fielding more unsolicited questions about munis from investors as the asset class gains traction.

Investors burned in the stock market last year are looking for a less-rocky place to put money, he said, and with taxes going up the new interest in munis will probably stick.

Take single-A 30-year munis, which according to the MMD yield curve offer a tax-exempt yield of 5.19%.

At a tax rate of 35%, the taxable-equivalent yield rises to 8%. At a tax rate of 39%, which is President Obama's proposal for the top tax rate, the yield leaps to 8.5%.

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