Buy Side

Muni Fund Rollercoaster Ride May Not Be Over

The recent bout of panic selling by investors in municipal bond funds reflects several factors, including headline risk due to predictions of widespread defaults, rising interest rates, the extension of the Bush-era tax cuts, and rallying equities.

As these events became the focus of investor attention late last year, the $464.6 billion muni fund industry was hit with an unprecedented wave of selling.

"The panic peaked in the middle and latter part of January, and that's evidenced by the muni mutual fund outflows," said Michael Crow, portfolio manager and senior municipal credit analyst at Glenmede Investment Management in Philadelphia.

The selling escalated when investors unloaded a massive $4 billion in the week ending Jan. 19, according to Lipper FMI.

Crow dodged the big selling wave, but is seeing consistent but modest outflows this month. His $145 million municipal intermediate fund and $31 million New Jersey portfolio saw net outflows amounting to 1% to 1.25% of assets since November.

To raise cash for redemptions in late January and earlier this month, he said he sold high-quality bonds maturing in the two- to four-year range as well as A-rated bonds maturing in eight to 10 years.

Several major fund companies declined requests to speak about how they managed through the dramatic sell-off.

But fund managers like Crow, who experienced lighter outflows, say they are aiming to stay fully invested in the nearly $3 trillion municipal bond market.

They say they don't subscribe to the predictions of massive defaults that have been swirling through the media. They are focusing on high-quality credits with 5% coupons or higher and managing duration risk to prepare for a potential rise in interest rates.

The latest weekly outflows have fallen to $973.9 million — still a high number — in the week ending Feb. 16, according to Lipper. In the Feb. 9 week, funds that report their figures weekly posted a net outflow of $1.16 billion. That was slightly higher than the $1.07 billion reported in the week ending Feb. 2.

Some fund managers say January principal and coupon payments to investors acted as a safety net to help them cover redemptions. Crow said he held onto the proceeds of Jan. 1 and Jan. 15 maturing bonds to build additional cash.

Municipal funds have reported $38.7 billion of outflows in the last 14 weeks, according to figures from Lipper. That's about a third of the $101 billion of inflows the muni fund industry sucked in from the beginning of 2009 to October 2010, when yields on Treasuries and money market funds were lower and the stock market was volatile.

While outflows have been moderating since mid-January — aided by a supply shortage that has kept yields well below 5% — municipals continue to face stiff competition. The budget crises spreading at the state and local level have many retail investors exploring alternatives to munis.

Since the end of October, the 10-year Treasury yield has spiked more than 90 basis points and the S&P 500 Index has gained 13.5% — two factors that have also lured some money out of tax-free funds, market experts said. Equity and taxable bond funds reported around $39.5 billion of combined inflows, according to the Investment Company Institute.

While the municipal market may have seen the worst of the outflows, "we haven't written the last chapter," said Jeff Tjornehoj, a senior research analyst at Lipper. He said the historic outflows were driven in large part by the passage of legislation by the Republican-led Congress at the end of 2010 that extended the Bush tax cuts by two years.

"Investors feel they no longer need as much of their assets protected by municipal debt," he said. "There isn't enough of a reason in the minds of municipal investors to put more money to work."

Instead, a large portion of that money is finding its way to domestic equity funds, which are seeing $3 to $4 billion of inflows a week, according to Tjornehoj. "There's momentum in equities and people feel more comfortable investing where gains have been steady," he said.

To make matters worse, muni funds are now facing scrutiny by the Securities and Exchange Commission. Examiners are requesting "a massive amount of information" about fund holdings in tender-option bonds, unrated and defaulted securities, and information about credit analysis.

According to a Wall Street Journal report last week, the SEC is investigating whether some funds overstated the value of high-yield municipal bonds that are infrequently traded.

Alex Grant, managing director and portfolio manager at RS Investments in New York City, experienced more outflows from his $100 million high-yield municipal bond fund, than his $280 million tax-exempt fund.

"There was concern about high-yield and that's where we did see outflows — but not as severe as other funds," he said.

Fund families that got hit the hardest, in his opinion, were those that suffered severe losses in 2008 and were still struggling to get back on their feet after one of the most tumultuous periods in financial history.

Shareholders in those funds were of the mind set that "I don't need another 2008," and likely sold on panic, according to Grant.

He attributed the modest outflows from his high-yield fund to its structure. With an overall credit rating of triple-B, it holds 13% in nonrated credits, as well as state GO bonds, like California, Puerto Rico, and Illinois. But it also holds A-rated bonds, adding a high-quality component, he pointed out.

"We tend to focus more on liquidity and higher coupons than riskier credits," Grant said.

That liquidity helped him recently raise cash for redemptions. "There's always an appetite for California 6% GOs, and Puerto Rico," he said.

The $4.2 billion Nuveen high-yield municipal bond fund saw its share of pressure from the sell-off, according to John Miller, co-head of fixed income at Nuveen Asset Management LLC.

In a recent municipal market update, he said the fund "has been hit harder than many of its peers due to the nature of the municipal market sell-off."

The yield-curve steepening and spread widening in certain sectors caused bonds with maturities beyond 10 years to sell off the most, Miller wrote in his report. The fund holds only 6.70% of its assets in bonds maturing under 10 years, while it maintains 31.18% exposure to bonds maturing between 25 and 29 years, according to information on its website.

"We are currently maintaining a consistent strategy, as we don't want to overreact to short-term downside volatility," Miller wrote. "We believe the fund is well-positioned for municipal market stabilization or improvement."

He noted that the fund had performed well during the municipal market's recovery period from January 2009 through October 2010, and is optimistic about a similar outcome in the current climate. While details on the firm's outflows were not available, its website said the fund had net assets of $4.54 billion as of Dec. 31.

"We believe the fund's valuation is attractive and our research team continues to look at all existing and potential new holdings from a bottom-up perspective," Miller added.

Others agreed that the market is relying on experiences learned in 2008 to get it out of the recent slump.

Grant said the market was "blind-sided" by Wall Street analyst Meredith Whitney, who in December panicked many investors when she predicted on national television that 50 to 100 municipalities would cause "hundreds of billions of dollars" in defaults this year.

"I think our shareholders saw how we performed in 2008, and had confidence in us managing risk, so they ignored the stories," he said.

RS Investments' fixed-income team manages $30 billion in assets, including institutional accounts and its brand of family of funds.

For his national fund, Grant invests in state GOs with strong credit quality and coupons of 5% or higher in 20 to 25 years. That allows for the most compensation for duration risk.

He also finds value in higher education credits, such as triple-A rated Harvard University 5.50% coupon bonds due in 2036.

Warren Pierson, a managing director at Baird Advisors and senior portfolio manager of the $203 million Baird intermediate municipal bond fund, attributes the greater stability of his fund during the sell-off to his bias toward high quality and emphasis on prerefunded issues, the latter of which "provided a strong base of protection against significant price declines."

With many investors recently seeing losses in their muni funds, many exited and opted for individual tax-exempt securities or taxable bond funds and equities, as those markets offered more opportunity, experts said.

Reid Smith, a portfolio manager at RBC Global Asset Management in Minneapolis, said the outflows demonstrated shareholders were seeking higher-income options, not panicking.

"I don't think that was the case this time, or you would have seen a pick-up in flows to money market funds," he explained.

"When yields rise, the yields on funds lag higher rates and investors sell lower-yielding funds to buy munis directly," Reid added. "Individuals might have bought munis directly because of higher-yielding opportunity and availability. Investors might have felt more comfortable in individual credits they knew."

Wooing investors back to municipal funds is possible, but might take some time, according to various sources.

Grant of RS Investments noted that states are turning to tax increases and cost-cutting measures. "I think that is all positive for the market and for shareholders stepping back into municipal bonds again," he said.

Crow of Glenmede Investments said the protests in Wisconsin over Gov. Scott Walker's plan to force state workers to contribute more to their health insurance and pensions is a "precursor" to additional headline risk for munis. That, in turn, could further spook retail investors, he noted.

Tjornehoj believes that additional negative press about budget strife will curtail investor demand for funds going forward.

"The shoe that we are waiting to drop is the financial condition of states and municipalities in 2011," he said.


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