High-profile municipal bankruptcies and potential defaults have not deterred the investing public from pouring money into municipal bond mutual funds.
So far this year, muni bond funds have had net inflows of more than $28 billion, according to Morningstar Inc.
That means that in less than seven months, the net flows for 2012 already represent the second-best year since 1993, when muni funds had net inflows of $34.7 billion.
The recent high-water mark was set in 2009 when muni funds had nearly $71 billion worth of net inflows.
It is a stark contrast to 2011, a year in which muni funds had nearly $12 billion in net outflows.
The direction of investor flows this year is even more significant when considering examples of state and local government challenges, including reports last week that San Bernardino could become the third California town in a month to file for bankruptcy protection.
The direction of investor flows is likely the result of a combination of the low-interest-rate environment and the general sense of calm coming from muni market analysts.
“When you look at the broader market what you find is, while we're seeing certain problems crop up, the numbers are still remarkably low relative to other asset classes,” said Stephen Winterstein, managing director and chief strategist of municipal fixed income at Wilmington Trust Investment Advisors.
The steady mantra from market watchers has been along the lines of putting the municipal bond market in context of 60,000 issuers of 1.5 million individual bonds, combining to create a $3.7 trillion market.
From that, Mr. Winterstein pointed out that the default rate has climbed to 0.5% from 0.4%.
“We have seen an uptick in defaults, no question,” he said. “But the defaults over the past three or four years have occurred in specific sectors like nursing homes, continuing care facilities, multi-family housing and single-family housing.”
Despite the sporadic and sometimes high-profile turmoil within the broader municipal bond space, the average muni bond fund return so far this year is 5.4%, according to Morningstar.
Last year the sector's average return was 9.3%.
Instead of dwelling on the economic troubles of places like San Bernardino or Scranton, Pa., which has cut all government employee pay to minimum wage, a lot of muni market watchers prefer to point out the efforts being made to fix the problems.
Detroit, for example, is calculated to be the poorest city in America, yet is not considered a serious risk to default on its debt.
“There are literally thousands and thousands of entities that are making the tough choices and doing what they have to do,” said Tom Dalpiaz, who manages $310 million worth of bond portfolios for Advisors Asset Management.
“The muni market is a bit of a puzzle, and you have to respect the complexity of it and the fact is, as an investor, you have to be vigilant,” he added.
Mr. Dalpiaz stressed that many of the financial problems facing state and local governments “didn't happen overnight, and there are usually signs of trouble that don't just come out of the blue.”
However, he added, analyzing the muni market also requires a certain degree of political analysis.
“Lower revenues and higher expenses are common problems, but the thing you cannot always see coming is the political willingness, or lack thereof, to make the tough choices and do the right thing,” he said. “There is no protection from a city or municipality just throwing up its hands and taking what they believe is the easy way out, but that doesn't mean we should all run from the muni sector just because we never know when a muni is going to throw up hands.”
Mr. Winterstein agrees that it would be easy to write off the municipal bond market as too risky, but he believes that would be an overreaction to the challenges facing the overall market.
“This is an asset class that is certainly not without its problems, but it would be premature to talk about an epidemic of defaults and bankruptcies,” he said.
Mr. Winterstein credited the controversial 2010 report by banking analyst Meredith Whitney with waking up state and local governments to some of the problems they are facing.
“Right now it seems like the muni market participants fall into one of two camps; they either think the sky is falling or they think this is the highest-quality asset class and there is nothing to worry about,” he said. “I think it's a high-quality asset class, but the municipalities have some problems that they need to deal with. In an indirect way, I think Meredith Whitney had a very positive effect on the market because, even though her numbers were wrong, she gave state governments and legislatures the political will to start to deal with some of the issues.”
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