Despite bankruptcies, muni funds rake it in

High-profile municipal bankruptcies and potential defaults haven't deterred the investing public from pouring money into muni bond funds.

So far this year, the funds have had net inflows of more than $28 billion, according to Morningstar Inc. That means that in less than seven months, 2012 already represents 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. That is in stark contrast to 2011, when muni funds had nearly $12 billion in net outflows.

The direction of investor flows this year is even more significant in light of continued pressure on muni finances. San Bernardino, for example, is the third California city in a month to declare its intention to file for bankruptcy protection.

SENSE OF CALM

Investor flows into muni funds are being driven by the environment of low interest rates and the general sense of calm emanating from muni market analysts.

Stephen Winterstein, managing director and chief strategist of muni fixed income at Wilmington Trust Investment Advisors Inc., noted that the muni default rate has climbed to just 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, multifamily housing and single-family housing.”

Despite the sporadic and sometimes high-profile turmoil within the broader muni bond sector, the average muni bond fund return is 5.4% so far this year, according to Morningstar. The sector's average return was 9.3% last year.

Instead of dwelling on the economic woes of places like San Bernardino or Scranton, Pa., which has cut pay for all government workers to minimum wage, a lot of muni market watchers prefer to point out the efforts being made to fix the problems.

For example, Detroit may be the poorest city in America, but it isn't considered a serious risk to default.

“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 Inc.

“The muni market is a bit of a puzzle, and you have to respect [its] complexity. The fact is, as an investor, you have to be vigilant,” Mr. Dalpiaz said.

He stressed that many of the problems that state and local governments face “didn't happen overnight, and there are usually signs of trouble that don't just come out of the blue.”

However, Mr. Dalpiaz said, examining the muni market also requires some 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.

Mr. Winterstein credited a controversial 2010 report by banking analyst Meredith Whitney for waking up state and local government to some of the problems they face.

“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. I think it's a high-quality asset class, but the municipalities have some problems that they need to deal with,” Mr. Winterstein said.

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