Cash hurts.
That painful truth is a primary pillar supporting municipal bonds today.
With safe, liquid, short-term products offering virtually no return, investors have little choice but to shuttle their money out of cash and into longer-term investments offering some return — any return.
That often means spiriting money into municipal bond mutual funds, whose yields far outpace those of tax-free money market funds.
Investors have ferried more than $106 billion out of tax-free money market funds in the past year, according to the Investment Company Institute.
During the week ended Jan. 13, tax-free money funds coughed up a stunning $9.06 billion — the heaviest exodus in more than a year.
Based on numbers from iMoneyNet, investors withdrew $7.67 billion from tax-free money funds during the week ended Jan. 18.
These massive outflows underscore a trend that helped shape the municipal market in 2009 and may be strengthening in 2010.
The stampede out of cash is a principal reason the Standard & Poor’s National AMT-Free Municipal Bond Index is up about 12% in the past year, even though state and local governments are suffering unprecedented budget deficits and shriveling tax revenue.
The trend is now so prevalent and important that Matt Fabian, managing director at Municipal Market Advisors, christened it with a name: “The Great Escape From Zero Percent Money Fund Yields.”
Here is how the story has unraveled:
Tax-free money market funds, which offer the equivalent of cash in the form of supreme liquidity and safety, on average yield a record low of just 0.02%, according to iMoneyNet.
A number of factors have yanked the rate down so low. The Federal Reserve has committed to keeping its target for interest rates extraordinarily low for an extended period of time.
That means other short-term instruments that compete for investors’ attention — bank certificates of deposit, for example, or Treasury notes — also carry low yields.
The average one-year bank certificate of deposit yields 1.55%, according to Bankrate.com, while the one-year Treasury offers less than 1%.
Also, tax-free money funds normally invest in paper they can force the issuer to buy back if they need the cash. Since few municipal issuers have that kind of capacity, this type of paper typically needs a credit guarantee from a bank.
The financial crisis eviscerated the ratings of many major banks, rendering these credit guarantees more scarce, and therefore more expensive and difficult to find.
That has led to a shortage of paper suitable for purchase by money market funds.
Issuance of variable-rate debt obligations that grant the holder the right to sell the paper back to the issuer tumbled 72% in 2009 to $32.5 billion, according to Thomson Reuters.
That represents famine for an industry managing $395 billion in short-term paper that is constantly maturing and needs to be reinvested.
The scarcity of eligible paper has led to ravenous competition for short-term tax-exempt notes. That has dragged down yields further.
Investors have grown increasingly impatient with yields approaching zero.
“The cost of staying in cash is quite painful,” George Friedlander, municipal strategist at Morgan Stanley Smith Barney, wrote in his latest report.
Investors who had their cash in money funds probably had it there in part because they did not want to risk losing it. So what do risk-averse investors who have grown intolerant of zero yields on money funds do with their cash?
In many cases, Friedlander said, they entrust it to short-term municipal bond mutual funds, often in the one-to-five-year maturity range.
“Some of this cash clearly migrated within or across fund families into longer-maturity munis,” Fabian said.
Municipal bond mutual funds reported $78.6 billion in new money from investors in 2009, according to Lipper FMI.
That is a record by far, and it helped the market absorb $409.56 billion of new municipal bonds last year — the second-highest total in history.
Chris Mauro, municipal strategist at RBC Capital Markets, in a report called investors escaping zero yields “money fund refugees.”
“Investors moving out the curve to escape paltry tax-exempt money market returns ... helped to create a supply/demand dynamic” that has bolstered municipals, he said.
Christine Albano contributed to this story.
