NEW YORK (AP) — Municipal bonds usually don't get much attention unless something's wrong. They're getting attention now.
Investors have been running away from bonds issued by state and local governments for several months, even though they offer tax-free income. The worries began when interest rates started to rise in the spring and heightened after Detroit became the biggest city in the country to ever file for bankruptcy.
The selloff is reminiscent of one that smacked municipal bonds in late 2010 and early 2011, following a prediction that a wave of defaults would hit the market. But now, like then, managers of municipal-bond mutual funds say the worries have created a buying opportunity.
Investors who bought in late 2010 did well: The average intermediate-term municipal bond fund returned 9 percent in 2011. Managers say such big gains aren't likely this year, but long-term municipal bonds can offer tax-free yields of 5 percent and have the potential to rise in price if interest rates don't take off, says John Miller, co-head of global fixed income for Nuveen Investments. Nuveen oversees $90 billion in municipal bonds.
Nearly every municipal bond mutual fund has lost money over the last three months. For a rebound in the municipal bond market to happen, it needs to snap out of the self-feeding selling cycle that has overtaken it.
Investors have been pulling money out of municipal-bond mutual funds since March, according to the Investment Company Institute. And the withdrawals have been accelerating: After yanking a net $1.8 billion out of municipal-bond funds in April, investors have pulled an average of $2.3 billion each week since the middle of July.
At first, the worries focused on rising interest rates. The yield on the 10-year Treasury note has climbed to 2.9 percent from a low of 1.6 percent in early May. Higher bond yields mean investors would rather own newly issued bonds, so prices for existing bonds with lower yields drop.
Detroit's bankruptcy filing in July raised further worries about the strength of the overall market. And after seeing prices for their municipal bond funds fall, investors pulled money out in hopes of avoiding future losses. But to come up with the cash to return to those investors, mutual fund managers had to sell some of their municipal bonds, which knocked prices down still further. That spurred even more fund investors to pull their money in a vicious cycle.
"That's a very short-term mentality," Miller says. "It has lasted longer than most municipal-market participants would have anticipated, but eventually that does stop."
He says the market could return to a virtuous cycle where buying feeds more buying, and he lists several positives for municipal bonds: Budgets for state and local governments are generally in better shape, inflation is low and yields are looking more attractive.
The last one is key: Municipal bonds can offer higher yields than similar taxable bonds. The advantage in yield is even more pronounced after taking the tax effects into account. The top federal income-tax rate is 39.6 percent, up from 35 percent last year. Investors who own municipal bonds from their home states can also avoid state income taxes. That means top income earners in in California or New York could avoid more than 50 percent in total federal, state and other income taxes.