Election Uncertainty Likely Spooks Investors in Muni Bond Funds

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Industry watchers cite election uncertainty as one big factor behind last week’s municipal bond mutual fund outflows, the first reported in more than six months.

Outflows occurred the week ended Oct. 31 despite positive movements in fund market valuations, according to JPMorgan. But the markets’ responses to the presidential elections and the potential makeup of Congress, the coming fiscal cliff and the possible threat to the tax-exempt status for muni bonds all combined to prompt investors to reconsider their allocations, industry watchers said.

Muni pros also see a timely rebound in the equities markets and fallout from Hurricane Sandy as having some impact on fund flows. Mostly, though, the unknowns of the election cast a lot of doubt and hesitation for investors in many asset classes, said Peter Delahunt, head of trading in the municipal bond department at Raymond James|Morgan Keegan.

“People want to keep their powder dry and take some chips off the table,” he said. “If Mitt Romney gets elected, for example, it could be seen to be good for the stock market and bad for bonds, to a certain extent. Investors have put some of those chips to work in equities.”

John Mousseau, a portfolio manager at Cumberland Advisors agreed, adding that, before the elections, where the outcome was more uncertain, investors wanted to know how the new Congress will treat muni bonds.

“Will it impose taxes, for example,” he asked. “There’s some of that fear factor going on.”

The market saw outflows to muni bond funds for the week ended Oct. 31, after 28 straight weeks of inflows. Funds that report their flows weekly recorded outflows of $123 million, Lipper FMI numbers show.

For the week ended Oct. 24, funds that report their flows weekly saw $666 million in inflows, a significant drop. But muni bond funds have still seen inflows for 57 of the past 61 weeks, and industry watchers still report healthy demand for munis among investors.

The outflows affected many types of bond funds, as well. Long-term bond funds that report their flows weekly saw strong outflows to the tune of almost $231 million from the $414 million of inflows they reported the week before. And high-yield funds that report weekly saw $86 million in outflows, Lipper said, after reporting $142 million in inflows the previous week.

Initially, some in the industry believed that the property and casualty insurance sector, which are traditionally heavy investors in munis, sold muni bond fund assets to cover expected claims from Hurricane Sandy. But Peter DeGroot, a muni analyst at JPMorgan disputed this in a research report.

Equity research analysts who cover the property and casualty insurance sector for the firm don’t expect that such businesses would sell assets to boost liquidity, based on preliminary estimates of up to $20 billion in insured losses, even though the losses related to the storm would likely result in a negative earnings event, he wrote.

One reason for this stems from the fact that the preceding hurricane season was relatively mild, leaving insurance companies on fairly solid footing pre-Sandy. In addition, insured losses even with Sandy aren’t expected to be substantially higher than the annual average.

Still, it is difficult to determine the degree to which retail investor attention was taken away from their money management concerns and directed toward the devastation of the storm, DeGroot said. In some cases, unanticipated  expenses stemming from the storm could have prompted withdrawals.

“The storm’s impact was likely greater from the perspective of diverting investor attention away from capital management than a reason for investors to reallocate capital,” he added. “This was also evidenced in retail-sized transaction volume which was 15% lower last week versus the year-to-date average.”

Still others, such as John Hallacy, manager of municipal bond research at Bank of America Merrill Lynch, speculated that investors might have perceived a shift in the muni market after its steady run, as refundings remain popular and new money supply has stagnated.

“It could be that some people think the profits in the muni trade have gone a long way and aren’t likely to go too much further, and is it time to go elsewhere,” he said. “We’ve had lots of tightening [in spreads] this year. Maybe all at once people have said: let’s take some of this money off of the table and put it elsewhere.”

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