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.