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ANALYSIS-Shrinking U.S. municipal fund outflows could signal end of exodus

Lisa Lambert
Friday, 10 Jan 2014 | 5:10 PM ET

WASHINGTON, Jan 10 (Reuters) - A record-setting flood of money from the U.S. municipal bond market may be near an end as the sector's high yields beckon investors bearing cash from year-end redemptions.

In a hint that the relentless sell-off that sucked $62.6 billion out of municipal bond funds in 2013 is winding down, data from Lipper on Thursday showed net outflows slowed to just $18.99 million in the week ended Jan. 8.

That was a mere sliver of the prior week's $1.47 billion of outflows and the four-week moving average of $1.17 billion. In all, last year's redemptions nearly matched all previous annual outflows combined and were more than four times the $15 billion yanked from municipal funds in 1994, the previous record year for outflows.

Moreover, the funds may soon see a few weeks of net inflows, said Tom Roseen, head of research services for Lipper, a Thomson Reuters company.

"This could be the beginning of people finally realizing they could get a better yield," he said. "The jump you get out of munis is huge, and that's before taxes."

As of Thursday, 10-year top-shelf municipal bonds were yielding 91.6 percent of comparable Treasuries, according to Municipal Market Data, a unit of Thomson Reuters. The yield on the municipal debt, though, is exempt from taxation while interest on Treasuries is taxed.

High-yield funds had net inflows this week of $49.98 million, after more than two months of weekly redemptions.

Roseen added that investors may believe they were "throwing the baby out with the bathwater" in fleeing the funds last year.

Spooked about the market's stability as both Puerto Rico and Detroit confronted huge fiscal problems, investors pulled their money out throughout 2013. There were only 11 weeks of net inflows over the course of the year.

But the rate of municipal defaults has remained low, while prices on both bonds and funds have become attractive to buyers and the higher yields are proving lucrative to investors seeking income, Roseen said.

"Given the losses and the rise in yields we saw last year, people may believe this is a better entry point than we had prior," said Morgan Stanley's chief municipal bond strategist, John Dillon. "Rates were rising pretty sharply, pretty significantly last year. That seems to have leveled off for the time being. That may entice some people to come in."

Dillon said expecting inflows may be premature, but "the magnitude of the exodus" will likely diminish.

Still, no one is expecting a sudden reversal. Last week was the 33rd week in a row money has washed out of the funds.

"While this week's muni fund flow figure is the best since May 22, 2013, when $63 million in inflows were reported, we don't think it definitively signals a turnaround in muni flows yet," wrote Chris Mauro, director of municipal bond research for RBC capital markets in a special note on the funds on Friday.

"We acknowledge that the trend is positive but view the current fund flow report as inconclusive given the significant amount of statistical noise around this week's number."

The biggest noise came from redemption money. Bondholders typically reinvest their principal and coupon payments in the market in January, and redemptions are expected to total $28 billion this month.

"Muni fund flows during the month of December were heavily influenced by tax loss selling," Mauro also wrote. "With the tax loss selling season now behind us, it's not surprising to see outflows diminish."

Interest rate risk led many investors to pull money from the funds in 2013. That could remain as the Federal Reserve begins to wind down its monetary stimulus program this year.

Long-term bond funds, those most sensitive to interest rate changes, registered $222.47 million in outflows this week, compared with last week's $1.23 billion in outflows, and were the lowest withdrawal since the week ended Oct. 30.

(Reporting by Lisa Lambert; Editing by Dan Grebler)

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