Interest rate fears causing muni bond pains

Interest rates have cooled off since they spiked in the second quarter, but investors are still running from municipal bond funds, causing the illiquid securities to underperform their taxable counterparts.
Investors pulled $9.7 billion from municipal bond funds in July, the fifth straight month of outflows for the tax-free vehicles, according to the Investment Company Institute. In total, nearly $30 billion has been withdrawn from tax-free-bond funds since the beginning of March, with $27 billion being pulled in just the last two months.
The selling isn’t likely to end soon. Municipal bonds are owned primarily by retail investors, who are much more likely to get spooked by losses caused by rising interest rates and the threat of bankruptcies such as Detroit’s than the more varied pool of taxable-bond investors, said Anthony Valeri, a fixed-income strategist at LPL Financial LLC.
The trouble began in early May when interest rate volatility began to rear its head. The 10-year Treasury went from 1.6% at the beginning of May to around 2.5% by the end of June. That 100-basis-point move caused the majority of this year’s fixed-income losses.
Interest rates on 10-year Treasury notes have since hovered between around 2.7% and 2.5%, but the damage may already have been done.
“Retail investors are still a little bit shellshocked,” Mr. Valeri said.
When municipal bond fund managers are forced to sell because of investor redemptions, prices can drop quickly since the bonds are traditionally among the least liquid fixed-income securities.
“In the muni market, the outflows can really feed upon itself,” Mr. Valeri said. “When there’s no one buying, prices start to spiral downward.”
The lack of buying has caused municipal bond funds to trail taxable-bond funds this year.
The average intermediate-term municipal bond fund had lost 3.33% this year through Tuesday, according to Morningstar Inc. The average intermediate-term taxable-bond fund, meanwhile, had lost just 2.12%.
As a result, advisers are hearing concerns from clients.
“When you have a May and June like we did, it does create some conversations,” said Neel Gammill, principal at Diversified Trust Co.
Mr. Gammill has reallocated about 5% of his clients’ municipal bond allocation into other asset classes, such as bank loans and master limited partnerships, rather than reinvest it in a rising-interest-rate environment.
“We’re not reinvesting as quickly,” he said.
There is some good news on the horizon for the muni market, however. The supply of municipal bonds on the market is slowing, which should help prop up bond prices.
In August, for example, roughly $30 billion of municipal bonds are scheduled to come due, but only about $10 billion is set to be issued, Mr. Valeri said.
Rising interest rates — and lingering worries in the wake of Detroit’s bankruptcy filing —also likely will curtail some municipalities’ plans to tap the debt market.
“If we see rates gradually rising, I don’t anticipate a dramatic increase in municipal borrowing for new projects soon,” said Rob Williams, director of income planning at The Charles Schwab Corp. “Less supply is going to be a factor in muni markets for some time.”
(Additional reporting by Brittany VanBibber)