Muniland’s flight risk

By Cate Long
October 31, 2012

I’m not a big fan of municipal bond-related mutual funds because some of their structural features work the opposite way that municipal bonds work. Mainly, the value of muni bond funds decline as interest rates rise. The WSJ.com has a useful description:

Advisers and investors appreciate being able to obtain even the current 1.8% yield from 10-year U.S. Treasurys. But many likely don’t realize the effects when interest rates rise, said James Swanson, chief investment strategist at MFS Investments. With the 10-year Treasury at a duration of about nine years, an investor faces a 9% cut to principal if interest rates rise 1% over the next 12 months and an 18% cut if rates increase 2%, he noted.

Did you catch that? If interest rates rise 1%, an investor could lose 9% of the value of his/her mutual fund. This negates one of the prime reasons to own municipal bonds for the long term:  the preservation of principle. If you are looking for the highest returns and you are willing to rotate into and out of bond funds as markets move, you might not suffer any principal loss. But that requires paying close attention to market direction and timing. Retail investors who are choosing retirement funds or putting aside cash are not generally good market timers. If an investor makes a choice and then sticks with it, the investment principal may be gone before they realize it.

I learned about an interesting structural problem with muni-related mutual funds yesterday when I was chatting with Tom Metzold, senior portfolio manager of Eaton Vance. He mentioned that unlike equity and corporate bond funds, there are no steady investor flows into municipal bond mutual funds. Since muni bonds are tax-free assets, placing them in a tax-deferred 401(k) account would actually increase an investor’s tax burden. So the steady inflows of investor cash that flow into equity and taxable bond funds does not provide ballast to muniland.

This lack of steady retail cash exposes muni bond mutual funds to much more volatility during periods of changing  interest rates and one-off spooks like when Meredith Whitney predicted a wave of defaults in muniland in late 2010.

All this argues for improvements in the abilities of investors to directly buy municipal bonds. Although the bonds may fluctuate in daily value, they almost always return the full amount of principal at maturity in addition to coupon rates. This is why current efforts of the SEC and MSRB to increase price transparency and disclosure for muniland is critical. Investors need alternative ways to access muniland than through mutual funds.

2 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

“I’m not a big fan” of fixed income specialists who don’t know the difference between “principal” and “principle”. This article is confused and confusing; a muddle of the impact of taxes and interest rates on the capital value of bonds with no mention of inflation. An article such as this one points out that those who seek to have a hand in regulating markets (such as the author) are sometimes the least informed – alas, another Elizabeth Warren wannabe.

Posted by StJohnsWood | Report as abusive

Cate, I don’t think it’s that simple. If your argument is that you are unlikely to find municipal bond funds in 401k’s and other tax-deffered accounts, then you you also have to acknowledge that such tax-deferred accounts are where people are more likely to do “market timing.” That means they are less likely to sell the muni funds in their taxable accounts, because they they might face taxes on their capital gains; and more likely to sell their treasury and corporate bond funds in their tax-deferred accounts, where they typically would face no capital gains tax consequence. The above suggests that muni’s could have an advantage in terms of the stability of their shareholder base at a time of rising interest rates.

Posted by Tschurin | Report as abusive