Municipal bond fund outflows and consistent equity fund inflows could be a sign that the so-called "great rotation" is on the horizon, according to one report. Other market participants attribute the outflows to other causes.
For the first time in nine weeks, muni bond mutual funds that report flows weekly
"In our view, [that week's] negative number, and the disappointing weekly prints leading up to it, may be early evidence of the much-discussed asset rotation out of munis and into equities," Chris Mauro, head of U.S. municipals strategy at RBC Capital Markets, said following the fund flow reports.
The idea of a "great rotation" arose last year, as record-low interest rates persisted and the Federal Reserve pledged to keep interest rates low until at least the end of 2014 or early 2015. Market participants have worried that this could prompt investors to rotate out of fixed income, including muni bonds, and into stocks, pushing bond yields higher.
Mauro and RBC associate Jordan Taylor believe these worries are justified for several reasons. First, they say that following a two-year bull market in munis, returns in 2013 will likely disappoint investors as a stable to rising interest rate environment will limit the potential for price appreciation and investors will be re-introduced to interest rate risk.
The RBC economic team is currently projecting the rate on 10-year Treasuries to increase to 2.40% by the fourth quarter of 2013 from approximately 2.0% currently.
"Additionally, a rising equity market, in association with the non-stop trumpeting of the global growth story by the mainstream print and broadcast media, could be an irresistible lure for those retail investors that habitually chase yield," Mauro and Taylor wrote in a report this week.
They also note that on a tax adjusted basis, the current dividend yield on the S&P 500 is competitive with the 10-year Municipal Market Data triple-A yield, potentially making a muni market with limited prospects for price appreciation somewhat more unappealing for some investors.
On Wednesday, Morningstar reported estimated U.S. mutual fund asset flows through February, noting that "risk-off" categories such as precious-metals, money market, and government-bond funds are seeing outflows, while bank-loan and emerging-markets bond funds see inflows.
"While not a clear sign of a great rotation out of bonds and into stocks, investors are taking more risk with their portfolios," ETF analyst Michael Rawson wrote in a report.
Vikram Rai, a municipal strategist at Citi, believes that such a rotation in the municipal market is not happening now and not likely to happen any time soon.
"Fund flow data has never supported the theory that cash flows out of munis winds up in equities," he said. "You might see cash flowing into equities and you might see cash flowing out of munis, but it's generally not the same cash."
In addition to historical data, the nature of the dedicated, retail-dominated investor base is another reason why a rotation from munis is not likely.
"It's unlikely that a muni investor will sell their muni bonds and put that money into equities," he said. "Muni bonds, in most cases, are lower risk investments and provide tax-exempt income and also coupon income. Equities are not a comparable asset class versus munis."
Cash will flow out of munis from time to time, but it usually sits on the sidelines because investors are either worried about credit, rising rates, or they feel that yields are too low, he said.
Even if cash flows out of munis causing yields to rise, it's likely that other buyers would come in and find those high yields attractive, according to Rob Williams, director of income planning at the Schwab Center for Financial Research.
"Individual bond buyers have been more hesitant to commit to individual bonds, looking for an opportunity to invest in decent yield and haven't found it, so that's a stabilizing factor on its own."
He also said he's not seeing a rotation happening and doesn't think it's likely given the continued demand for yield by retail and institutional investors.
"The municipal market still is relatively appealing to high net worth investors, certainly relative to Treasuries, and the supply in the market remains tight," he said. "One week of data is a very short-term trend and it does not indicate to us a 'great rotation' risk. There are other reasons to buy muni bonds."
Williams said that some of the recent outflows may be attributable to the positive performance in the stock market, the change in consumer sentiment and the impact of tax season, wherein investors are selling bonds in order to pay taxes.
While he has not seen a rotation out of munis, Williams has instead seen a duration rotation within munis, where investors that aren't comfortable taking interest rate risks have shifted out of long-term bonds.
"So rather than rotating out of fixed income, we've seen more interest from investors in short- and intermediate-term bonds," Williams said.
