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Bond Fund Purchases Carry Risk

MAY 15, 2012 7:19pm ET
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Individual investors have been flocking to municipal bond funds, searching for safety and relatively high yields.

But for investors buying long-term bond funds, the search for yield farther out on the curve could expose them to risks they may not have calculated. They could gain little in longer-duration munis if interest rates hold, and they would be negatively affected if rates rise, industry pros say.

The recent increase in demand for long-term funds stems from a couple of factors. For one, more investors have pumped coupons and principal reinvestments into long- and high-yield muni funds as they try to maintain a reasonable rate of return in a low interest-rate environment, Chris Mauro, director of municipal bond research at RBC Capital Markets, wrote in a market post.

In doing so, they have shown that they’ve made an adjustment in their appetites for risk. High-yield bond funds invest in low-rated and below-investment-grade securities.

In addition, municipal bond fund flows, in general, have likely benefitted from the weakening of equity fund flows, George Friedlander, a muni analyst at Citi, wrote in a research report.

“If you look at the flow of funds between equities and fixed income, it’s astounding that even in this low-yield environment people continue to gravitate toward fixed income,” said Peter Hayes, head of municipal bond trading at BlackRock,

Flows into long-term bond funds have represented more than 50% of aggregate muni bond flows for most of the last month. For the week ended May 9, of the total net inflows of $901 million for all weekly reporting muni bond funds, long-term funds that report flows weekly comprised $498 million, Lipper FMI numbers showed.

From the first week in April through Monday, the 30-year triple-A yield has dropped from 3.42% to 3.05%. And the influx into long-term bond funds played a role, according to Priscilla Hancock, executive director and muni strategist at JPMorgan Asset Management.

“The flow of money into longer funds is one of the things that’s pushing down the 30-year part of the curve,” she said.

But retail investors are painfully aware that there’s so little income in the fixed-income markets today that they’re reaching down the credit curve and out on the yield curve. In the process, they’re exposing themselves to more risk for possibly little payout.

If rates remain exactly where they are today, the total return for investors — price appreciation and coupon — would likely be minimal once you venture out past a 12-year investment, Hancock said.

“While you might pick up a little extra in coupon, you’re losing a little in price return,” she said. “So, for people who are looking more at coupon than they are total return, you’re not getting a lot, at this point.”

Additionally, rising rates would be a problem to investors in long-term muni funds. Hancock said this is because even modestly rising rates affect longer-duration bonds more.

“Because retail investors are always thinking about when, not if, interest rates are going up, it takes a pretty good leap of faith for them to move into long-term funds on a consistent basis,” BlackRock’s Hayes added. “And here we are, in a low-yield environment, so they’re moving out the yield curve to try to capture more income.”

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