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The three scariest things about municipal bonds

When it comes to municipal bonds, the headlines can drown out the news.

Horror stories from Chicago, Detroit and Puerto Rico, painting a harrowing financial picture amid talk of budget shortfalls and potential defaults, mask a sector that is otherwise pretty sound.

Since the financial crisis and accompanying recession, states and municipalities have in fact gone in a diametrically opposite direction from their counterparts at the federal level. In the aggregate, states and municipalities cut debt each year since 2011, though the first quarter of 2015 saw a 4.8 percent increase, according to the Federal Reserve. At the same time, the federal government has been piling on debt, rising in each respective year 11.4 percent, 10.9 percent, 6.5 percent and 5.4 percent.

"Not just for states but also for local governments, economic conditions are the best they've been in years," said Dick Larkin, director of credit analysis at HJ Sims & Co. "Most states and cities are seeing a resurgence in tax receipts, they're seeing improvements in their financial position, and there should now at this point be more (analyst) upgrades than downgrades."

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Yet investors are getting a little antsy.

Over the past 12 months, the $3.7 trillion muni sector has seen a net inflow of $28.8 billion in investor cash, according to Morningstar. But the group saw $594 million in outflows during May and another $1.2 billion in June.

While most analysts agree the picture overall remains positive, there are three factors generating some anxiety:

The pension problem

Amid the efforts to reduce debt and institute better financial practices, states remain burdened with heavy pension woes.

Public pensions generally speaking have mirrored the mess in their corporate counterparts and their $389 billion funding gap (as measured by Howard Silverblatt, senior index analyst at S&P Dow Jones Indices). Unlike corporate pensions, though, the picture for state governments is actually improving, albeit modestly.

The public pension funding level increased from 72 percent in 2013 to 74 percent of obligations in 2014—again, no great shakes but at least progress, according to a study from Boston College's Center for Retirement Research.

Required contributions to pension plans rose from 17.8 percent of payrolls to 18.6 percent, and the percentage of required contributions paid rose to 88 percent from 82 percent, according to the study.

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Boston College researchers Alicia H. Munnell and Jean-Pierre Aubry concluded that the pension picture "should continue to improve," with funding hitting 81 percent by 2018. But that's based on an important caveat, that "what happens from here on out depends very much on the performance of the stock market."

With many Wall Street equity experts predicting a lower-return environment ahead, that could be problematic for pensions.

"That gets a lot of publicity. That's the hot word in municipal bonds: Where are you on pension funding?" Larkin said. Though he thinks Illinois and New Jersey have particularly thorny problems with the issue, he believes that any full-blown crisis is "still a couple years down the road."

Rising rates

Bond yields present a challenging question for fixed-income investors: While the hunt for yield trade has been a dominant investing theme for the past six years of zero short-term interest rates, it also can be trouble for bond funds that count on rising principle value. Yields and prices move in the opposite direction, so higher rates can eat into principal.

The prospect for the Federal Reserve to start hiking rates, probably later this year, thus has cast some doubt on the muni landscape.

While most believe the U.S. central bank will go slow with its pace of hikes, the situation contains at least some level of uncertainty, particularly if inflation should accelerate.

Julio Bonilla, portfolio manager for the four-star Schroder Long Duration Investment-Grade Bond Fund, said the fund's investment goals are met by not focusing on rates and instead on quality and duration.

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"We run a variety of strategies—short, intermediate and long. We don't make interest-rate bets. What we do is manage to the duration," he said. "It's really tough to make interest-rate bets. When are the rates going to move? How much are they going to move? How are the parts of the curve going to move?"

Bonilla said the 11- to 12-year area is alluring in terms of duration.

''If you're able to take the duration risk, there's some school of thought that if rates start to back up and take some of the inflation risk off, yields should compress and offset any interest-rate move you get," he said.

A game of emotions

As much as any asset class out there, munis are driven by sentiment, which in turn is expressed through fund flows, or the measure of how much is going in and out of the sector.

With money leaving in May and June, that's a pretty good indicator that at least in the near term, munis could undergo some turbulence. While bond experts see rate risk as a larger danger, never underestimate the impact of headline risk.

"A particular weakness of the municipal bond asset class is its propensity to be driven by retail investor sentiment," said J.R. Rieger, global head of fixed income at S&P Dow Jones Indices. "You've got Illinois, Chicago, New Jersey—there's a myriad of other potential news items that can hit. All of that can change the sentiment of the retail investor."

In a year when returns have been unspectacular—the Barclays Municipal Bond Index is up just 0.21 percent in 2015—the various tremors and land mines can cause broader problems and sharper reactions.

"We haven't seen as robust a performance this year, but it's kind of a bifurcated market," said Adam Buchanan, senior vice president of institutional sales at Ziegler, a specialty investment bank.

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"We're tracking fund flows really closely, specifically tax-exempt fund flows," he added. "When you have a sustained period of significant outflows, that has correlated pretty directly with challenges in munis. You couple that with the inability of banks and large broker-dealers to bid and keep an orderly market because of constraints that have been put on them with legislation, and that could be a challenge."

For investors looking for telltale signs that deeper problems are ahead, HJ Sims' Larkin recommends watching California, which has gone from muni-mess poster child to darling of the space, with its Barclays index up 0.3 percent in 2015. As an example, he said California announced this week that it won't need to take out a revenue anticipation note as it awaits tax receipts. When that changes, Larkin said, it will be a good tell that the muni market is changing as well.

"California, they're just blowing through the roof on their finances," he said. "But they can go from the land of milk and honey to the guy on the streets saying, 'Lend me money, federal government. Please bail me out.' Right now California is the Golden State."

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