Why Muni Bonds Are Suddenly So Popular With Investors
Investors are barreling into municipal bonds, driving yields to record lows and hoping for a safe hiding place at a time when taxes are almost certain to rise.
From Nov. 7 to 12, about $500 million of new money flowed into muni bond funds, according to Lipper U.S. Fund Flows. That compares to $866 million for the entire week ended Nov. 7 and is about the same as the four-week moving average.
"The argument that's been made for at least the last six months, is that on relative value basis, it's better to buy a muni than a Treasury because it's tax-advantaged," said Peter Bianchini, managing director and senior municipal bond strategist at Mesirow Financial. "If you were to buy a triple-A-rated state versus the U.S. government, they're both fairly safe credits. With the end of the election last week, there was this new sentiment — tax rates are going up."
The charge by investors into the tax-free securities has been creating a surge in demand that is not quite being met by supply and is causing some to question whether the muni bond market could be heading for a bubble.
(Read More: Tracking Market Sentiment on the 'Fiscal Cliff')
"If you look at the flows into municipal bond funds, they've been very high. That's driving this," Bianchini said. "From a trading standpoint, it's hard to find bonds. New deals go away right away."
He added: "Maybe there is a bit of a bubble, but it's probably the same bubble Treasurys are experiencing."
But some muni bond experts don't see signs of a bubble building.
"The reason that I believe it's not a bubble is because a bubble is something that's unsustainable and bursts," said John Donovan, head of municipal bond trading at Cantor Fitzgerald. "This is because there's an imbalance in supply and demand, and that imbalance is being caused by large inflows into mutual funds and concerns about the tax exemption being more valuable post-election." Typically what happens in situations like this is that issuers start to match demand, he added.
Bond experts describe a trend of new investment in munis that accelerated after President Barack Obama was re-elected, because he was seen as more likely to push tax hikes than Republican candidate Mitt Romney. Obama has repeated his pledge to raise taxes in the past week, ahead of his meeting with congressional leaders Friday.
As a result of the "fiscal cliff" negotiations, investors expect to see taxes rise, possibly in the form of higher rates or the loss of deductions, or both. The so-called fiscal cliff is the potential $607 billion hit to the economy from taxes and spending cuts starting Jan. 1, if Congress doesn't act.
Investors have also been reacting to the strong possibility of a boost in the current, expiring 15 percent dividend tax rate. That could make investments, like municipals, an attractive alternative. It is also possible there will be a higher capital gains tax rate, another element of expiring Bush-era tax cuts. High-income tax payers will also automatically pay 3.8 percent more on certain types of investment income because of the Affordable Care Act, starting Jan. 1.
The muni bond market had been depressed by worries about credit quality and fears of default, but over the last year it's been catching up, said Phil Condon, Deutsche Bank chief investment strategist for fixed income. "I think the market has gone through this and the high grade munis, they're a pretty good asset class. It's been a safe place to be and people are coming home. I would recommend high grades versus high yields in this market," he said.
The 10-year Treasury note was yielding 1.59 percent Tuesday, while the MMD 10-year generic AAA muni was yielding a record low 1.55 at the end of the day Tuesday. Treasurys have been seeing safe-haven buying as investors worry about the fiscal cliff, and rates have moved lower in the past week as result.
One trader described the muni market as being at a "high-water mark" for momentum, where this new hunt for tax free investments coincided with typical year-end buying, though some of the insurers and hedge funds appear to be less active. "Mutual funds are getting a lot of money in. That positive cash flow needs to be spent, so I don't believe we're creating a bubble. This isn't speculative money. It's real money chasing after it," he said.
There are other potential risks.
"The fiscal cliff strikes me two ways," said Mesirow Financial's Bianchini. "If taxes are going to rise, people should buy more munis. We're seeing that already, but the other side is as part of the fiscal cliff, do we see some tax reform that eliminates the tax-exempt status of munis?" He does not see the elimination of the exemption as a likely outcome, but it had been raised by Romney. Bianchini said it might be more likely that the amount of income an investor could receive tax-free would be capped.
Deutsche Bank's Condon said the majority of muni issues are safe bets, and two-thirds are revenue bonds. "If you're looking at names of a certain size, names people would recognize, it's untypical to have problems there," he said. Condon said he favors the bonds of entities, like water and sewer utilities, and the best value he now sees is in major airports.
"There are 50,000 fiscal issuers out there, and you can find hundreds of examples of problems out there," he said. Condon said investors should look to the top names, noting it's the smaller entities that are more vulnerable to events.
If the 10-year note rate falls much more, the divide between high-grade and lower-quality munis will become more apparent, Condon said. "If it goes lower, high-grade (munis) might follow it. High yield might not because you're forecasting more troubles," he said.
Condon also sees no sign of a bubble, but he is concerned that investors at some point will find themselves overly invested in bonds in general. The ratio of the 10-year triple-A-rated muni Tuesday was 97 percent, meaning that security was paying 97 percent of the equivalent Treasury, well above the long-term average in the low to mid 80s.
"If you can buy high grade munis at close to 100 percent of Treasurys, you tell me what the bubble is," Condon said.
—By CNBC's Patti Domm; Follow Her on Twitter @pattidomm
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