If the clouds hovering over the municipal bond industry have a silver lining, portfolio managers say it is investors finally giving them cash to work with when yields are compelling.

Municipal portfolio managers have long lived with an infuriating paradox: investors deposit money into funds when bond yields are low and withdraw money when yields are high.

This is human nature.

When bond yields are high, it is precisely because people are worried about inflation or bad credit or illiquidity. Portfolio managers would say that is the best time to put money in, not take money out.

Investors in the muni market do not typically heed that advice.

"Investors tend to sometimes be momentum-driven," said Brad Durham, managing director at EPFR Global, a firm that tracks mutual fund flows.

Durham said retail investors tend to be especially backward-looking, pursuing returns already reflected in prices.

That has implications for the muni market in particular because retail investors own more than 70% of the $2.67 trillion of outstanding munis, either through direct ownership or through investment funds.

In mid-September, shortly after the Lehman Brothers Holdings Inc. bankruptcy, municipal bond portfolio managers saw an unusual opportunity.

The average yield to maturity in The Bond Buyer index broke 6% for the first time since 2000. Since 2000, munis rarely offered such plump returns. The yield was under 5% for most of 2007.

The excitement did not last. That week, investors withdrew $396.7 million from muni mutual funds, according to AMG Data Services.

A few weeks later, the yield to maturity in the index catapulted to 6.78%, the plumpest yield since 1995.

Many portfolio managers were unable to capitalize. Investors spirited $2.29 billion from muni funds that week, according to AMG.

Based on AMG data, the 10 biggest weekly influxes into muni funds between mid-2006 and the end of last year came during weeks when the average yield to maturity was less than 5.2%.

In May 2008, muni funds attracted more than $5 billion in cash flow, according to the Investment Company Institute, by far the biggest monthly inflow in the last two years.

During the entire month, the average yield to maturity did not exceed 5.2%. Conversely, muni funds suffered significant outflows the last 15 weeks of 2008. Investors withdrew $8.36 billion in October alone.

As money drained from their funds, muni portfolio mangers wrung their hands: yields on munis were never so attractive. The five biggest weekly outflows since mid-2006 all took place in late 2008. All occurred when The Bond Buyer index yield to maturity was north of 6%.

Since the beginning of 2009, portfolio managers have enjoyed a rare confluence of inflows and compelling yields.

Investors are pouring an average of nearly $1.2 billion into muni funds a week, according to AMG Data.

Meanwhile, the yield to maturity on The Bond Buyer index has been at more than 5.5% the entire year. A year ago at this time, the yield was a percentage point lower.

"Right now, it's an exception," said Dick Berry, portfolio manager at Invesco AIM. "It's a good time to have the inflows."

Berry said the relative yields of munis over Treasuries were too heavy to ignore.

The yield on 10-year, triple-A munis reached 186.1% of the 10-year Treasury on Dec. 18, according to Municipal Market Data, which is more than double the average ratio since 2000.

Yields like that can only persist for so long before investors take notice, Berry said.

The ratio has since subsided to 95.35%, still high but closer to the traditional relationship.

The inflows this year are welcome, if not belated.

For most of the second half of 2008, portfolio managers touted munis as unprecedentedly cheap. During the week ended Oct. 15, the average price in The Bond Buyer index was 81.97, implying the cheapest prices since 1994. The index had not even ducked below 100 since 2000.

That week, investor withdrawals from muni funds were more than double the withdrawals of any other week since at least 2006.

During weeks like that, portfolio managers wish they could be buying bonds, not selling them.

"It's the crowd psychology," Berry said. "When interest rates are high, people are generally bearish, worried about inflation, worried about economic recovery. ... Naturally, we'd rather have the money come in when the rates are at the high part of the cycle."

Berry said a portfolio manager whose clients bucked the buy-high, sell-low trend would probably be able to generate better returns than other managers.

James Colby, who is now senior municipal strategist at Van Eck Global, remembers when Lord Abbett & Co. hired him in early 2006 to launch a high-yield muni fund.

Rates on high-yield munis relative to yields on investment-grade munis had peaked more than two years earlier and were in decline.

By the time the fund launched and gathered significant assets in the first quarter of 2007, Colby said, high-yield rates relative to investment-grade bonds were at their lowest in years.

Rampant demand for high-yield munis coupled with insufficient supply meant investors were stuffing funds with cash and portfolio managers did not have many attractive opportunities, Colby said.

"When I started up the fund, clearly the challenge was to keep up with the new cash that was coming into the fund on a monthly basis," he said. "I'm not sure we were getting the proper risk-reward relationship. In fact, I'm certain of it. As a portfolio manager sometimes you can't fight the tape. When the cash comes in, as an open-ended mutual fund manager sometimes you have a very difficult time turning it away."

Berry cited 1994 and 1999 as particularly bad periods when investors ignored attractive yields to the dismay of portfolio managers.

According to ICI data, investors withdrew money from bond funds in all but two months from March 1994 through March 1996. The investors taking money out missed year-over-year returns of 10% or more for the final 11 months of that period.

Beginning in September 1999, bond funds suffered 16 straight months of outflows.

Starting with the final month of that period, the bond market delivered an uninterrupted year of monthly year-over-year returns in excess of 11%.

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