The sophisticated investor in retail municipal bonds has remained calm the past few months even as mutual funds have dumped state and local government debt by the truckload.
The private wealth investor’s resolve has prevented the exodus of cash from mutual funds the past 10 weeks from exploding into a full-blown panic enveloping the broader muni bond market.
Private municipal investors — who manage their own portfolios or keep their money in separately managed accounts and trusts, rather than mutual funds — are a different breed of animal from mutual fund shareholders.
Private accounts’ preferences for buy-and-hold investing and shorter-term debt have kept money from leaking from private accounts the way it’s bled out of mutual funds.
“Totally different story,” said Gary Gildersleeve, a portfolio manager at Evercore Wealth Management, a private wealth manager with $2 billion in assets. “We haven’t seen the same thing [as the mutual funds]. There’s obviously a lot of nervousness, but I think for the most part, if you’ve done your hand-holding and you’re continuing to assure clients, there hasn’t really been a problem.”
Municipal bonds have been getting rocked since the summer. The yield on a triple-A rated 30-year muni has swelled nearly 130 basis points since the end of the third quarter.
The culprit is nearly $30 billion of investor withdrawals from municipal bond mutual funds since early November.
Those outflows prompted managers in the $478 billion muni fund industry to liquidate holdings to raise the cash to redeem investors.
The result has been a flood of sell orders at a time of rising interest rates and uncertainty over the durability of demand for municipal debt.
A Bloomberg LP index tracking bids-wanted for municipal bonds hit a record $1.4 billion last month. It was at $1.33 billion Wednesday. Market participants say those bids are sought mainly from mutual funds.
The fund redemptions seem to reflect the retail investor’s backlash against “headline risk” stemming from a relentless flurry of dire forecasts from the likes of Meredith Whitney, the prominent banking analyst who last month predicted hundreds of billions of dollars in municipal defaults.
In fact, though, mutual fund investors hardly constitute the entirety of retail demand.
Retail investors own an estimated 70% of the $2.8 trillion of outstanding municipal debt, while mutual funds own about 17%.
Retail investors also use closed-end funds, exchange-traded funds, unit investment trusts, and money market funds to gain exposure to the asset class.
Wealthy investors entrusting money directly to wealth managers in private accounts are a major component of the retail buy-side. These investors typically are more savvy than mutual fund investors, fund managers say, and know enough to hang in during sell-offs like the one now rumbling through the municipal industry.
That means they know better than to lock in losses by following headlines.
“What we’ve been seeing on that side is actually clients asking us, 'Is this a good time to add money?’ ” said Michael Schroeder, chief investment officer at Wasmer, Schroeder & Co., which manages $4 billion in private money. “'Should I be extending duration, because that’s where the yield is?’”
A variety of characteristics distinguish the typical mutual fund owner from the typical separately managed account investor, rendering the latter a buyer — or at least a holder — while the former is selling.
The primary disparity is the personal relationship that affluent investors enjoy with their managers, which permits more discussion about the municipal asset class when credit concerns arise.
Considering professionals within the municipal industry are almost unanimously dismissive of Whitney’s forecast, this provides a buffer between the investor and a hasty sell order.
Neil Klein, a portfolio manager at Cray Asset Management, said 20% to 25% of his clients have called him to ask about the headlines over munis. After having a conversation, few decided to sell, he said.
“Our selling has been very, very muted,” Klein said. “Even though we’re a conservative investment firm, we still believe that holding the positions that we have makes good sense. We don’t necessarily need to sell because of the current concerns in the marketplace.”
Schroeder said when clients come to him with concerns about headline risks, he asks them to evaluate why they are in municipals in the first place, and whether the allocation can still meet those objectives.
Most people buy munis for tax-exempt income and preservation of principal. So far the hysteria hitting the market hasn’t hampered either of those goals.
Private investors by nature are averse to long maturities. Such investors typically stay in the intermediate range, perhaps less than 10 years. Because of a plethora of technical factors, long-term municipal bonds have been over-represented in the selling of the past three months.
The Standard & Poor’s index tracking returns on short-intermediate municipals is down 1.69% over the past three months. The main index is down 6.3%.
Schroeder also pointed out that mutual fund redemptions can feed on themselves. When a mutual fund is forced to collect a weak price for a bond to meet a redemption, the remaining shareholders suffer from a drop in asset values.
In that sense, it might actually be a good idea to redeem mutual fund shares rather than be stuck with losses from liquidations to redeem other investors’ shares. Private accounts, meanwhile, do not affect other private accounts.
One of the features that makes mutual funds appealing to investors — the ability to redeem — may also lead to the shares being sold more. While it is easy to cash-out of a mutual fund, municipal bonds themselves are often illiquid.
An investor who owned bonds directly and wanted to sell at a time like this would probably have to accept a “haircut” to find a buyer, sometimes getting trimmed by as much as 2 or 3 cents on the dollar.
It’s possible much of the money escaping mutual funds is the same hot money that rushed into them when the sector was hot. Municipal bond mutual funds reported more than $100 billion of inflows in 2009 and the first 10 months of 2010, according to the Investment Company Institute. The outflows the past 11 weeks have reversed almost a third of that.
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