Muni funds take on water as rates rise

Municipal bond funds are starting to sink as interest rates rise. The yield on the benchmark 10-year Treasury note has soared from a low of 1.37% July 8 to 2.40% Monday, sending bond prices plummeting. Municipal bond funds, whose interest is generally free from federal taxes, haven't been exempt from the pain. Investors — largely steered by advisers — have poured an estimated $61.4 billion into muni funds the past 12 months, according to Morningstar. Funds that invest in long-term bonds with the shakiest credit have been hit hardest. Long-term California munis, for example, are down 6.6%, including reinvested interest, since the July low in interest rates. High-yield munis are down 6.1% the same period. "What have sold off are the riskier strategies," said Todd Rosenbluth, director of ETF and mutual fund research at CFRA. "Basically, that's the nature of muni bonds," Conversely, funds that buy short-term, high-quality paper have fared the best. Short-term muni funds have fallen an average 1.85% since the July low in rates. Two bright notes: The carnage in the worst muni funds hasn't been as extensive as the losses in the worst taxable funds. The worst muni fund to date is Nuveen California High Yield Municipal Bond (NCHRX), an $800 million long-term fund that has shed 9.71% since rates started rising. The institutional fund charges 0.65% in expenses and has an average effective duration of 10.56 years, Morningstar says. Average credit quality: BB. In contrast, Vanguard Extended Duration Treasury Index (VEDTX), a $1.1 billion fund, has plunged $21.2% since July 8. While the fund invests in high-quality Treasury securities and charges just 0.06% in expenses, its average duration is 24.73 years. Results for munis were similar in the exchange-traded universe. The top performer was PowerShares VRDO Tax-Free Weekly ETF (PVI), which has gained 0.14% since rates bottomed in July. The $58.6 million fund yields 0.56%, charges 0.25% in expenses and invests primarily in variable-rate demand obligations, which minimizes interest-rate risk. The worst muni ETF in this cycle: VanEck Vectors CEF Municipal Income (XMPT), down 12.63%. The $87.2 million ETF invests in closed-end muni funds and has a 1.52% expense ratio. Retail investors, who dominate the municipal bond fund market, tend to focus more on tax-free income rather than total return. "Relative stability is particular appealing for these folks," Mr. Rosenbluth said. How long will the selloff go on? Chris Alwine, principal and head of Vanguard's municipal bond group, thinks that the current level of rates discounts much of the future economic growth (and inflationary pressure) from the incoming Trump administration. "The bond market is factoring in a decent improvement in growth and a fairly aggressive Federal Reserve," Mr. Alwine said. "It has gotten a little ahead of itself."