Municipal bond funds are in the midst of their worst sell-off ever, and there doesn't appear to be an end in sight.
Investors pulled $1.2 billion out of municipal bond funds during the one-week period through Oct. 16, according to Lipper Inc. It's the 21st week in a row that the tax-free-bond funds have been in redemption mode. Over that time, more than $53 billion has been pulled out in total. That's more than was pulled out during the Meredith Whitney scare and during the financial crisis.
“It's the worst period in my 25-year career,” said Tom Metzold, co-head of municipal investments at Eaton Vance Management.
Because municipal bonds are held primarily by retail investors, the sell-off has created a market with lots of sellers and few buyers. That means prices are falling faster than their taxable-bond-fund counterparts, which count institutions, hedge funds and banks among their investors.
The average intermediate-term-municipal-bond fund fell 2.89% year-to-date through the end of Oct. 16, according to Morningstar Inc. The average taxable-bond fund fell just 1.43% over that same time period.
The main reason for the sell-off is fear of rising interest rates, which is scaring off retail investors, said Peter Hayes, head of the municipal bond group at BlackRock Inc.
The 10-year Treasury's yield rose more than 100 basis points from 1.6% in May to the end of June and even hit as high as 3% in September. It's since settled to around 2.6%.
Those moves were enough to send a chill up investors' spines.
“Investors are convinced rates are going to go up,” he said. “The market isn't convinced, if you look at the 10-year, but investors are.”
Mr. Metzold said it's easy to see why muni bond investors would be particularly worried about rising interest rates.
“A lot of people investing in municipal bonds today were around in the 1970s and '80s, when rates got really high,” he said.
Further complicating matters in the muni market are the high-profile struggles of Detroit, which became the biggest U.S. city to declare bankruptcy in July, and the continuing struggles of Puerto Rico.
Those fears, combined with worries over rising interest rates, make it hard for Mr. Hayes to see retail investors coming back anytime soon.
“I don't see retail investors coming back for some time unless we get really higher yields,” he said.
Richard Steinberg, president and chief investment officer at Steinberg Global Asset Management Ltd., is one of the advisers moving clients away from their traditional allocation to municipal bonds because of the low rates and interest rate risk.
“There's no great return in munis today,” he said Thursday at the S&P Municipal Bond Forum in New York.
Mr. Steinberg has moved some municipal bond assets into higher-yielding taxable bonds and shortened the duration of the existing municipal bond portfolio, which lowers the already low-return potential but eliminates some of the interest rate risk.
When intermediate-term municipal bonds start yielding closer to the 4% his clients are used to, he'll consider moving them back in.
“We're biding time on the low end,” Mr. Steinberg said.
One looming event that could give muni-averse investors a wake-up call is tax season. This year is the first that the highest earners, those with $450,000 or more, will feel the full bite of tax increases from the fiscal-cliff deal and the Affordable Care Act.
Those high-income investors could see their taxable income raise by 30% this year, making the tax-free allure of municipal bonds all the more alluring, Mr. Metzold said.
Also working in favor of municipal bonds is the slowly strengthening economy, which will lead to higher tax revenue for municipalities, so the already low default risk could drop even lower for the majority of issuers, he said.