Record municipal bond outflows last week represent a short-term blip in the market, according to some industry sources. The underlying causes were uncertainty about tax rates and Build America Bond subsidies, as well as seasonal supply and demand conditions, they said, all of which should be resolved or normalize by early next year.
According to the Investment Company Institute’s weekly data, mutual funds in the municipal bond category lost nearly $4.8 billion in assets for the week ending Nov. 17. This compares to $115 million in outflows in the prior week. But year-to-date, municipal bond mutual funds have gained $30.29 billion in net flows, ICI said. Lipper, which used a different sampling, had municipal outflows at $2.99 billion for the week, the highest level of outflows in a single week since 1992.
Brian Reid, chief economist of the ICI, believes the outflows were to be expected given recent municipal bond performance. For the month of November, the S&P National AMT-Free Municipal Bond Index, which tracks the tax-exempt municipal bond market, has fallen nearly 5 percent, according to Reid. But prices have already begun climbing again after reaching a low last week, he said.
“We believe the recent drop in municipal bond prices reflects a temporary supply and demand imbalance related in part to the recent election results and new uncertainty about future tax rates and the Build America Bond program, rather than a deterioration of municipal credit conditions,” said Tom Faust, chairman and CEO of Eaton Vance, during the firm’s fourth quarter earnings conference call.
Alan Zafran, a partner with Luminous Capital, a wealth management firm, also cites the Build America Bond program as a cause for declining bond prices.
Concern surrounding the possible expiration of the Build America Bond program has caused municipalities to issue additional Build America bonds before year-end, jacking up supply, which depressed prices. The legislation created a new category of taxable municipal bonds, designed to facilitate financing of state capital expenditures and operations. Under the program, the U.S. government would pay 35 percent of the interest on taxable bonds.
The new Republican majority in the House of Representatives is less supportive of federal government subsidies for the states, which spurred uncertainty about whether the legislation would be extended into 2011, said Zafran. If the program is not extended, municipalities would have to raise money in the traditional bond market and offer higher yields to attract investors.
On the other hand, on Wednesday, Bloomberg reported that a bill is pending in the Senate that would extend the program through next year, although the subsidy rate would be cut to 32 percent.
The outflows last week may also represent a delayed reaction to the election results and uncertainty around the Bush tax cut extensions, said Jeff Tjornehoj, head of Lipper Americas research. Tjornehoj believes the outsized outflows are temporary and that municipal bond mutual funds should have small outflows and possibly even inflows this week.
Normal seasonal conditions may also merit blame for the outflows, according to Zafran; typically the market sees lots of supply through Thanksgiving, and it slows down in December, when government officials take vacation. In addition, most bonds mature in January, he said, so investors will take their year-end bonuses and coupon payments and reinvest in bonds.
Faust said he expects demand to pick up in 2011, and he sees municipal bonds to be an attractive opportunity now.
Zafran also sees an attractive opportunity in this market, but only for a short-term trade in longer-term and high-yield municipal bonds over the next few months. Although municipal bonds across all credit qualities were hit, the majority of the outflows came from these longer term higher-yield bonds, he said.
Looking longer term, he sees the opportunity in short- to intermediate-term investment grade municipal bonds. “I want to be in the stuff that’s not going to default.”
As the market gets back to stable supply and demand conditions, which he believes should happen around late January to mid-February, these are the types of municipal bonds investors should look to.
