Muni bond funds enjoy newfound popularity

In what advisers say is a flight to safety and returns, municipal bond funds attracted more than $20 billion in new cash from January through May 13, according to the Washington-based Investment Company Institute.

That’s a sharp turnaround from December, when investors fled the funds, yanking out $4.3 billion more than they put in.

One reason for muni bond funds’ newfound popularity is the returns.

General municipal debt funds had an average year-to-date return of 11.99% as of May 21, according to New York-based Lipper Inc.

Short and intermediate muni funds had an average return of 5.38% and single-state munis averaged a 9.95% return for the same time period.

The funds were beaten so low last year, the only way to go was up.

“The funds got really knocked down in 2008,” said Jeff Tjornehoj, a Denver-based senior research analyst with Lipper.

“They were priced in the market to assume that the default rates were going to be astronomical. By the fourth quarter, people said that is just not going to happen. At that point there was huge interest in muni bond funds.”

While municipal defaults are rare, there is still risk.

“There is still a chance that some of these funds won’t be okay, but it’s a fairly remote chance,” Mr. Tjornehoj said. “I think the risk still tends to sit with the municipality. And they are going to pay more to get funded.”

Another risk is inflation and rising interest rates.

Investors are attracted to muni bond funds for safety, income and out of a fear of equities, said Dan Traub, president of Tempo Financial Advisors LLC of Natick, Mass., which has $20 million in assets under management.

But they need to pay attention to interest rates, which will follow the government’s spending to fuel economic recovery.

“You can make all the yield you want, but you won’t make money if rates go up,” he said.

“Ultimately, interest rates will go up and that won’t be good for muni bond funds. Muni bond fund buy-and-hold investors may not be happy over the next few years.”

With muni bond mutual funds, there is no maturity date and an investor could sell the fund and lose the initial investment. An individual muni bond has a maturity date and investors know that if they hold onto the bond until that date, they will at least get their investment back.

Still, an actively managed muni bond fund has professional management to offer.

“With a muni bond fund, you get someone who is managing the fund for a relatively constant duration,” Mr. Traub said. “You are not going to have to worry about reinvesting.”

And the funds can offer diversification, which is harder to achieve with individual muni bonds when an investor has a modest amount of cash allocated to these funds, said Carolyn McClanahan, founder of Life Planning Partners Inc., a Jacksonville, Fla., firm with $25 million in assets under management.

But it’s just a matter of time before interest rates go up, she said. “If you need to sell the fund when the interest rate is high, you could lose significant capital.”

Still, returns are better than those of Treasuries and people are willing to take that risk, Ms. McClanahan said.

There is uncertainty about the muni bond market, particularly when investors read that the Department of the Treasury is considering whether to guarantee California state debt, said Robert Wasilewski, an investment adviser at Baltimore-Washington Financial Advisors Inc. of Columbia, Md., which has $180 million under management.

“I prefer to use individual municipal bonds,” he said. “Every particular muni bond has a story to it. I feel I know more about the specific issuer. That gives me more comfort.”

That said, he tends to focus on highly rated general obligation bonds.