Mutual Funds at New High

Municipal bond mutual funds’ assets climbed to a new record total as they continue to command new money from investors in spite of low yields and a nonstop wave of bad headlines in the mainstream press over state and local government credit.

During the week ended July 14, investors entrusted $612.5 million to municipal bond mutual funds that report their figures weekly, according to Lipper FMI.

Based on the weekly reporting funds, investors have bestowed new money on the municipal fund industry 12 out of the past 13 weeks.

Among all funds, including those that report their figures monthly, inflows have averaged $359 million a week the past four weeks — still solid, but far below the record pace of nearly $2 billion a week established late last year.

Municipal funds commanded $78.55 billion in new money last year, and recorded $42 billion in market gains.

Inflows for 2010 now exceed $20.7 billion, according to Lipper, which combined with $15.2 billion in market gains has pushed the industry’s assets to a record $502 billion. The industry has grown 47% since the end of 2008.

Jeffrey Cleveland, an analyst with Payden & Rygel, said that while low nominal yields and constant bad press may have turned some retail investors off, the lighter pace of inflows has done little to harm municipal bond values.

The five-year triple-A municipal yields just 1.4%, according to Municipal Market Data. That just about matches the record low established in December, when inflows were at their peak. Municipals have returned 4.3% this year, according to the S&P National AMT-Free Municipal Bond Index.

The reason, Cleveland said, is the supply of tax-exempt bonds continues to dwindle, as about a quarter of new issues are siphoned into the taxable market through the Build America Bonds program.

Supply of new tax-exempt paper is down about 22% this year, according to Thomson Reuters.

“It may be a little less to do with demand and more to do with the supply situation,” Cleveland said.

Payden & Rygel runs two municipal funds with about $70 million in assets. The national fund, with an average maturity of seven years, yields 2.44% based on the latest dividend.

The BAB program is widely expected to be extended, promising to continue poaching supply from the tax-exempt market.

So could the technical imbalance last indefinitely, keeping municipal yields perpetually low?

Cleveland thinks if yields keep sinking, they eventually will reach a level where they repel retail investors.

“At some point, there’s a floor that you run into,” he said.

Cleveland pointed out that yields are not as low as they may seem. While nominal yields have never been lower, a mild inflation rate means the real return on bonds is still normal, historically.

The consumer price index fell 0.1% in June, the Bureau of Labor Statistics reported last week. That means essentially none of the 2.6% yield on the 10-year is being eroded by inflation. Compare that to, for example, this time 10 years ago, when the 10-year yielded 4.85%, and a 2.1% inflation rate rendered the real yield to 2.7% — almost the same as today’s.

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