Municipal bond funds have reported outflows for 11 straight weeks, as investor confidence gave way to concerns over the credit of such issuers such as Puerto Rico and Chicago and the probability of rising interest rates.
While municipal bond funds have attracted a net inflow of $3.209 billion for the year to date, according to Lipper FMI, last week's outflow was the 14th out of the 29 weeks, or just less than half.
Flows turned negative during tax season, a trend that has continued through June and July as Puerto Rico's government acknowledged that the island's $72 billion of debt was unpayable at current levels of economic growth, Moody's Investors Service cut the credit rating of Chicago, the nation's third-biggest city, to junk, and the Federal Reserve signaled a possible rate increase this year.
"I don't think it's due to poor performance -- munis have held up pretty well" said Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management. "But I do believe there is a market nervousness about the Federal Reserve and the upcoming interest rate rises."
He added: "There's a lot of nervousness about Puerto Rico. They're in a tough spot."
Retail investors are the backbone of the municipal bond fund sector, and wealthy mom and pop investors often have different aims, objectives and fears than market professionals.
Some of the redemptions this year have been related to seasonal factors, such as tax-filing deadlines and coupon payments, analysts said. Others, however, have been caused by the headline risk surrounding financial problems in Puerto Rico and Chicago as well as further afield, in Greece and in China.
Van Eck Global's senior municipal strategist James Colby said municipal bond funds have been hurt by the deteriorating financial situation in the commonwealth of Puerto Rico: "Mainstream news articles showed how widely Puerto Rico credits were held -- and I emphasize the word 'were' because many investors told their advisors 'get me out' and some professionals said 'these securities don't fit with our investment criteria anymore.'"
As of June 29, about 53% of open-end mutual funds had at least some exposure to Puerto Rico debt. That's down from 54% in February and 69% in February 2014, according to Morningstar Inc.
Another factor in the weekly outflows, some analysts said, could be the mediocre performance of the overall municipal bond market so far this year.
For the six months ending June 30, the total return for the Barclays Municipal Bond Index was a meager 0.11%. In contrast, the Barclays Muni Index had a total return of 9.05% for all of 2014. The return on the Barclays High-Yield Municipal Bond Index was -1.92% for the first half of this year.
"We're not even earning the average coupon in the marketplace," Colby said. "While we didn't lose, we didn't win a lot."
The BofA Merrill Lynch Municipal Securities Master Index has returned 0.319% for the year through July 16, according to Bank of America Merrill Lynch Global Research. The index, however, outperformed both BAML's Treasury Master Index and its U.S. Corporate IG Master Index, which had total returns of -0.037% and -0.557%, respectively.
The worst sector for muni performance so far this year has been in high-yield, which saw a total return of -3.976%, according to BAML.
"Negative returns and the flight from Puerto Rico have driven high-yield muni mutual fund outflows," BAML said. "The correlation between the total return of high-yield index and fund flows is high."
Colby said that retail investors continue to look at the municipal bond market as a unique entity, one that is supposed to deliver a constant income stream while providing high-credit quality.
When that doesn't always happen, it causes anxiety and "it plays into some of the redemption flows."
Some investors felt it was just better to exit the muni market now and then revisit it at a later date when things had calmed down, he said. He added that while investors are quick to leave, they are slow to come back.
Is there a silver lining?
"If interest rates rise and refundings recede, we may not see all of the volume that was predicted at the beginning of the year," Colby said. "Potentially there may be more dollars chasing fewer bonds in the second half of the year. We will see whether the demand side will lead to better performance."
It's not the time to be out of the muni market, he said, because of the opportunity that may lie ahead.
"As I look at yields rising, and performance at or near zero," Colby said, "I am optimistic at the possibility of having a pretty strong finish for municipal bond performance in 2015."
