Municipal Bonds: Outflows = Opportunity? Part 2
My recent post on outflows in the municipal bond market drew a few responses from readers. One noted that there were a number of similar factors in both the 2010-11 and current municipal bond market environments, in addition to the months-long periods of outflows, that may have contributed to the decline in market prices and commensurate increase in yields. That is certainly true; markets are complex organisms with many participants all operating on what they believe is reliable information, and acting in their best interests. Now, whether or not each person buying and selling into the same market is acting on “enlightened self-interest” is not clear at that moment, but their collective actions are what make markets (apologies to Alexis de Tocqueville). Markets are judged by their price action and their supply-demand factors.
Flows and possible factors
In reviewing the Lipper Analytical Services monthly inflow and outflow numbers for municipal bond funds in 2010, the market had positive inflows until November 2010. The outflows greatly accelerated in December and January of 2011, and stayed negative through the end of May. Obviously all of those outflows were not due to one analyst’s appearance on 60 Minutes, but it is not a bad example of what people often call “headline risk.” Negative or incendiary headlines (predicting “hundreds of billions” in losses) often lead to a “shoot first, ask questions later” reaction from market participants. Some other things that market participants were worried about in late 2010-11, as well as today, concern the potential end of quantitative easing, the fiscal health of many states, overall economic conditions, fallout from prominent defaults such as Detroit, tax revenues at the state and federal level, and let’s not forget Puerto Rico. So there is never a shortage of reasons investors give when they are buying or selling securities, and the municipal market is no exception.
Potential action plan for 4Q and year-end
To repeat my closing comments from the original post, suitable investors may wish to consider the risk-return factors of municipal bonds and decide if this an attractive entry point. Investors currently holding municipal bonds or muni closed-end funds may wish to explore some tactical year-end tax planning involving tax-loss harvesting and/or swapping. Investors that sell securities at a loss and purchase different securities with similar credit quality and/or yield characteristics may be able to reduce their capital gains exposure or lower their overall tax obligation, while maintaining exposure to that asset class as part of their overall portfolio. Fixed income instruments will continue to play an important part of well-diversified portfolios, and many times the decision to take advantage of market opportunities created by above-average selling pressure look good down the road as the markets recover.
All fixed income securities are subject to two types of risk: credit risk and interest rate risk. Credit risk refers to the possibility that the issuer of a security will be unable to make interest payments and/or repay the principal on its debt. Interest rate risk refers to fluctuations in the value of a fixed income security resulting from changes in the general level of interest rates.
Economic and regulatory factors may affect a municipal security’s value, interest payments, repayment of principal. An issuer’s failure to comply with tax requirements may make income paid thereon taxable, thus reducing the security’s value. In addition, there could be changes in applicable tax laws or tax treatments that reduce or eliminate the current federal income tax exemption on municipal securities or otherwise adversely affect the current federal or state tax status of municipal securities.Tags: