3 Signs That Municipal Bonds Could Be in Trouble

Jeffrey Coolidge | Getty Images

March has seen a fairly brisk exodus from municipal bonds in what could be the first signs that investors are beginning to worry about fixed income.

The popular government finance instruments have seen fund outflows of more than $500 million—just a fraction of the $608 billion asset class but a move that caught some bond pros by surprise. The most recent week saw $261 million come out of the market, according to Thomson Reuters.

While munis often see investors take profits in the springtime as they raise cash to pay taxes, the selling this year came a bit sooner than usual and appeared at least in part unrelated to the normal ebb and flow of fixed income trading.

"Some observers have attributed the sharp outflows over the past few weeks to seasonal patterns ... but we disagree," George Friedlander, Citigroup's chief municipal strategist, said in a note to clients. "There is a real risk the negative pull of seasonality is yet to be felt."

If the trend continues for munis, it could provide the first signal that the much-anticipated "Great Rotation" of money from bonds into equities has begun. Stock market bulls cite the prospects for the paradigm shift in investor behavior for their belief the equity market will keep rising.

(Read More: American Dream Is Back, So Are Stocks: CNBC Survey)

It also could provide proof of another oft-cited forecast—that the 30-year bull run for fixed income is near its end.

"It's really too early to tell, although the pattern does look like it's starting to gel," said Chris Mauro, head of U.S. municipals strategy at RBC Capital Markets. "We've had weakening muni flows at the same time we've had strong equity flows. But it's really too early to tell whether that pattern has taken root."

Even though munis are only on a three-week decline in terms of fund flows, three principal factors are presenting challenges to the group

1. The (Not-So) Great Rotation

If there is a rotation in place, it certainly isn't happening with other bonds.

Fixed income overall remains a popular place with investors, who have poured more than $16 billion into taxable bonds over the past month, according to the Investment Company Institute.

But stocks have taken in money as well, so it's understandable if bond investors are starting to hear footsteps behind them in the equity markets.

(Read More: Investors May Hate Bonds, but They Keep on Buying)

The main concern is whether investors seeing bonds at extremely low yields are becoming concerned the party is over.

"Direct retail demand for munis has been quite weak for a number of months, as individual investors remain extremely cautious about investing or reinvesting in muni at levels near historical lows," Friedlander said.

2. About Those Rates ...

As Friedlander alluded to, the days of high capital appreciation and lower yields could be in danger particularly in a muni market where issuance has surged—a condition that usually leads to higher yields and capital depreciation.

Fund investors feel that bite particularly hard and may be more tempted simply to lurch over to the equity side, where Federal Reserve policy is keeping the liquidity taps flowing but could become less effective in controlling rates if the economy continues growing.

"The equity market is doing extremely well, so you have a very enticing equity market and you have concerns of rising rates," Mauro said. "In a rising-rate environment where you're going to have a limited potential for price appreciation, and maybe see negative prints on monthly statements, the soaring equity market looks pretty enticing."

(Read More: Fed's $4 Trillion Question: Where's the Exit Door)

For the year, The Barclays municipal bond index is little changed, while the Standard & Poor's 500 has gained more than 9 percent.

3. The Washington Wildcard

Outside of the challenge from the stock market, munis face another enemy: politicians.

Looking to find ways to cut spending and increase revenue, some in Congress are targeting municipal bonds for their tax-exempt status. A plan on the table would put a 28 percent cap on the exemption.

"We view that as dead on arrival," said Drew Nordlicht, managing director and partner at High Tower Advisors in San Diego. "The cap on the muni tax rates would have a material impact on absolutely everybody."

(Read More: Kudlow Says There's No Sequester Catastrophe)

A widely disseminated study from a consortium of local officials pegged the lost benefit to localities at $173 billion.

Despite the uproar the move likely would spur, the measure continues to receive attention in Washington, and that chatter has made its way to Wall Street.

"Such a significant change could alter what has served as one of the most efficient forms of government and infrastructure financing for more than a century," said Daniel Solender, director of municipal bonds at Lord Abbett.

However, he said the change could occur if not this year then in 2014.

The culmination of factors, then, could give investors pause about whether to commit more money to munis.

"What we're seeing is an opportunity for investors to reposition portfolios," Nordlicht said. "We are decreasing duration to five- to 11-year maturity and see this as an opportunity for investors to upgrade credits. But we see continued demand in the municipal market."