JANUARY 18, 2012, 7:41 P.M. ET
Article from Smart Money
Municipal bonds were among the few breakout stars of 2011, but some advisers warn the hot streak may fizzle out.
By JONNELLE MARTE
In last year's upside-down market, the once-forsaken muni bond became a surprise hit, offering investors safety and solid returns. But as their popularity continues to grow, some pros are warning investors their stellar run may be coming to an end.
With the fears of defaults now a distant memory, investors plunged nearly $5 billion into municipal bond funds in December -- the category's highest total in 16 months, according to fund researcher Morningstar Inc. That's a sharp reversal from the 5-month period that ended in May, when they yanked nearly $23 billion from these funds. And the money is still flowing in: municipal bond funds, including exchange-traded funds -- drew in in $1.1 billion for the week ended Jan. 11, their highest amount since March 2010, according to fund tracker Lipper.
Why the stampede back into municipal bonds? For starters, advisers say many investors who were spooked by grim predictions for large defaults in the municipal-bond market last year are returning now that it hasn't come to pass. Other investors are likely chasing returns, analysts say. The average long-term national muni-bond fund gained 9% in 2011, compared to a 2.1% gain for the S&P 500, according to Morningstar. "I don't think anybody was predicting such strong returns, says Jim Colby, senior municipal strategist and portfolio manager for Van Eck Global.
And while yields on the bonds hit record lows last week, advocates say the bonds still pay better yields than other kinds of bonds. The weighted average yield of bonds in the S&P National AMT-Free Municipal Series 2021 Index, which tracks investment-grade, tax-exempt municipal bonds, was 2.4% at the end of December, for a taxable equivalent yield of 4.35%. That compares to 1.9% for a 10-year Treasury bond. "We're still finding attractive yields," says Dan Loughran, senior vice president of OppenheimerFunds and leader of the Rochester municipal investment team.
Still, muni-bond bears say these investments are plenty risky. As part of the federal government's effort to reduce its massive deficit, several lawmakers -- as well as President Barack Obama -- have proposed cutting or eliminating the tax break on income from municipal bonds for high earners; as of now, muni-bond income is tax-exempt. If that tax exemption vanished, investors would demand higher yields, and muni-bond yields would jump dramatically, says , says Matt Fabian, managing director of Municipal Market Advisors, a market research firm. Bond prices fall when yields rise.
Another potential blow: approval of the so-called Volcker rule, a proposal that aims to limit the bets banks make with their own money, could reduce the number of banks buying municipal bonds, which could lower bond prices, says Fabian. And hot interest municipal bonds have seen over the last couple of months could backfire if an event spooks investors and causes them to flee from the funds, warns Fabian. "As fast as they're putting money in they can pull money out," he says.
On top of that, the recent rise in popularity is pushing down yields even just this year, giving the upper hand to issuers, who get to borrow at lower rates, says Fabian. For example, a standard Triple-A rated municipal bond yielded 1.73% as of Jan. 18, down from 1.93% on Jan. 2, according to Municipal Market Advisors. Even fans point out that muni-bonds' best days may be gone. "We've had yield plus price appreciation because the market has rallied," says Loughran,. "But I encourage people not to expect that from municipal bonds going forward."
Article from Smart Money