What's the Allure of Municipal Bond Funds?

James Colby, Senior Municipal Strategist and author of the Muni Nation blog at Van Eck, talks about what the long string of cash inflows into municipal bond funds tells us about market demand. He also discusses where to find the best value in muni funds and talks about the gaining popularity of closed end funds.

VOICE OVER: Chip, This has been a very interesting year coming off a strong 2015 and a strong 2014. I would say the market participants weren't really sure what to expect. Of course it all hinged on what the Federal Reserve was going to do and what the economy was going to show in terms of performance, but demand has been strong. We have had well over 30 consecutive weeks of inflows. The roll over, which is the coupon and maturity re-investment continues to go back into Muni's as opposed to finding some other products, and we've also experienced some foreign demand for investors looking for income in the face of negative returns and negative rates overseas. Demand so far for all classes of municipal bond funds has been nearly 22 billion year to date, and about 1.8 billion of that has gone into Muni ETFs.

The beginning of the year, we talked about the potential for the Fed to move maybe as many as four times raise rates, up north of 1%. What would happen under those circumstances? Recent history tells us, going back to 2003 to 2006 when last the Federal Reserve moved aggressively, the O-curve flattened and the performance or the opportunity was in the long end of the O-curve because as rates rise, as you know, Fed funds moves the short end of the curve higher, the long end of the curve tends to remain relatively neutral.

That's exactly what's been happening so far this year. We've seen a flattening of O-curve, we haven't seen anything quite as dramatic as we've seen this year since 2008, and the year to date numbers I think support our thesis because total return has been derived in the long end of the marketplace, whether we're talking about high yield or investment grade.

The MMD O-curve for example has dropped year to date some 37 basis points, and the short end of the curve has risen to a modest extent but still representing the flattening process so far to date, and I think plays out through the rest of this year. The long term investor, the opportunity exists for the long term investor to allocate resources out in the 20 to 30 year part of the curve and we'll be rewarded for that.
Closed in funds are receiving attention, I think for one primary reason. The prior question in my answer I touched upon, the O-curve flattening and the opportunity for the long investor to reap rewards in terms of total return. That plays in perfectly to what closed-end funds are all about, and in addition, they employ leverage, some up to 30% of assets under management which boosts the yield. It's a yield play, a long-end play and investors certainly have become very interested in closed end funds.

I might mention that the closed-end fund of funds, symbol is XMPT, so far year to date is the second best performer of any municipal mutual fund. Last year it was the top performer in terms of total return. Right there, you have a perfect example of why people are taking a second look if not putting their money to work in closed-ends.

It's awfully hard to predict what the Fed Reserve is going to do, Chip, but it appears that they, meaning the Fed Reserve, very much want to move rates higher. They want to seize on any opportunity to make that move, and whether that means one or two times through the remainder of 2016, can't really make that prediction, but all things being equal, if we get those two moves, we continue to see the market behavior the way it has behaved in the first five months of the year I think we will have another positive performance year overall for Muni's. Flows will stay strong. The opportunity to reap awards in the long end of the curve will continue to be there, and investors, whether they're domestic or international, will see Muni's as a source of strong credit quality and positive returns.