Retail investors in municipals are shaken, but still standing, after a relentless barrage of negative media hype surrounding forecasts for massive municipal bankruptcies and defaults later this year.
Mom-and-pop individual investors are taking different paths — both conservative and risky — to navigate the murky tax-exempt market, experts say.
They have been bombarded with a swarm of negative headlines following the nationally televised prediction in December by Wall Street analyst Meredith Whitney that there will be widespread bankruptcies and “billions of dollars in defaults” by 50 to 100 municipalities in 2011.
“It appears that the wave of selling generated by acute credit fears has calmed down in the last two weeks,” noted Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia.
According to Lipper FMI, weekly outflows from muni bond funds moderated to $1.07 billion for the week ending Feb. 2 — the second consecutive week of lower outflows and the lightest pace since early December.
Outflows began moderating the week ended Jan. 19 when redemptions totaled $1.9 billion — roughly half of the historic $4.2 billion the week before. Outflows are estimated at $12.9 billion in January alone, according to preliminary figures from the Investment Company Institute.
Jumpy individual investors were unnerved by Whitney’s comments because they seemed convincing given the existing weak market fundamentals, analysts said. With municipal and Treasury yields inching up during the fourth quarter, a January sell-off hit the $471.81 billion municipal mutual fund industry hard. Fund selling to meet share redemptions exacerbated the price declines.
“Retail investors are still bitterly divided about the risks and the opportunities in the municipal market, but they are not panicking like they were for several weeks,” said Anthony Parish, vice president of fixed-income and product specialist at Deutsche Bank in New York.
“They have stopped running and are now taking a break to reassess the situation,” he said.
Sources say the reduced outflows indicate a willingness by many investors to stay in the game.
But according to a monthly consumer confidence survey from RBC Capital Markets, some are having a harder time than others brushing off Whitney’s market-moving predictions.
According to the survey, 62% of Americans are not confident in municipal bonds as an investment.
“The consumer response confirms that the continual stream of news stories about state and local government fiscal problems is having a negative impact on investor perception,” Chris Mauro, head of municipal bond research at RBC, said in a report about the survey. “The results are consistent with the sizable outflows from municipal bond mutual funds.”
“Given the current challenging budget environment, consumers will likely continue to see these negative headlines for at least the next several months,” he warned.
The historically safe nature and low default rate even among small, nonrated issuers in the tax-exempt market set retail investors up for a big fall when they heard Whitney’s prediction.
“We didn’t have any expectations of default built into our market before, so it’s unnerving and it disturbed their mind set,” said Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management in Oak Brook, Ill.
Although Whitney’s highly publicized forecast is still fresh their minds, many retail investors are putting the headlines aside and dusting themselves off after a month of wear and tear in the media and markets, sources said.
Many are utilizing investment strategies that run from minimizing risk and remaining conservative to maximizing opportunities for higher yield by considering lower credit quality and extending maturities.
“We did have a few customers that had concerns, however, by no stretch of the imagination were we inundated with calls,” said Bill Mason, senior vice president of sales, trading, and underwriting at David Lerner & Associates in Syosset, N.Y.
The yield backup, as well as the attractive ratio of tax-free municipal interest rates to taxable Treasuries continue to drive retail demand, according to Mason.
“Retail appears to be taking advantage of levels that are substantially cheaper than they were a few months ago,” he said.
For instance, the 10-year triple-A municipal yield reached a high of 104% of the 10-year Treasury yield in January. In addition, the generic, 30-year, triple-A general obligation bonds backed up 124 basis points to 4.92% on Feb. 4, compared to 3.68% on Sept. 1, according to Municipal Market Data.
Secondary market investors are gravitating toward slight discount bonds on the long end of the yield curve in the GO and essential services sectors, Mason said. He noted that New York City Municipal Water Finance Authority revenue bonds with a 5% coupon due in 2034 were trading at a 5.20% yield last week — 91 basis points cheaper than where the credit’s 4.50% coupon bonds due in 2038 were trading back on Sept. 9.
“In a world filled with uncertainty, tax-free municipal bonds offer investors a taxable equivalent yield of over 7%,” Mason said.
The water revenue bonds exemplify the structure preferred by Lerner’s clients.
LeBas, too, said there is a retail appetite for the long end of the market.
“We’ve seen an increase in a willingness to take on longer bonds, particularly once 30-year, high-grade yields crossed above 5.05%,” he said.
Demand is being driven by attractive yields and an easing of investor concern, according to LeBas.
“I don’t think we’ve seen a change of market opinion overall, but rather the shaking out of investors who held pessimistic opinions,” he said.
After being reassured about the long-term track record and fundamental strength of municipal credits in general, many jittery clients who earlier wanted to sell their muni holdings decided to stand pat.
“At the height of worries in January the majority of individuals looking for bids on their holdings declined to sell,” LeBas noted.
Retail investors at Janney are currently partial to par coupon bonds ranging from 4.75% to 5% in 20 years and beyond from double-A-rated GO and essential-service revenue issuers, he said.
According to LeBas, there has been a noticeable spike in demand in the New York region among “sophisticated” retail investors “that are less likely to be swayed by sensational news coverage.”
Others let panic get the best of them and jumped ship.
“Unfortunately, with this much negative publicity it’s almost certain a large number of retail investors sold at an unjustified level of fear,” said Chris Mier, managing director and municipal strategist at Loop Capital Markets LLC in Chicago.
Back at Deutsche, Parish said investors who feared losing their principal were involved in a lot of “indiscriminate selling” in the market overall from mid- to late November through the first half of January.
“The scar tissue from 2008 is still very thin with many municipal bond investors, and some were erring on the side of caution and went into cash for a while,” he said, referring to the peak of the financial crisis.
“By mid-January, things turned around and there were buyers in the market who recognized that the yields got to attractive levels that brought in buyers, stabilized the market, and caused several days of positive returns,” Parish added.
Deutsche has a total of $28 billion in municipal assets under management — $10 billion of which represent retail municipal assets.
Parish said the firm’s retail investors are divided into two camps — a strategic investor that prefers high-quality with shorter durations, and a tactical investor seeking yield.
The strategic investors are reducing their credit and interest rate risk. “The sweet spot for these retail investors is an average credit quality of double-A and an average duration of four to eight years,” Parish said.
On the other hand, the tactical investors are increasing their credit risk by buying high-yield funds, for instance, because they have sold off the most within the last three months.
“Investors who believe the sell-off was overdone and the municipal market is getting ready to snap back are invested in closed or opened-ended high-yield funds,” Parish said.
The recent reduction in mutual bond outflows is a step in the right direction, he noted.
Although net sellers outweighed net buyers last week, he said continued cross-over buying by large institutional accounts and taxable investors chasing taxable equivalent yields could help flows in coming weeks.
Some retail investors are waiting for yields to rise to and remain at a 5% threshold, and for the recent market volatility to subside, before they become net buyers, Deutsche said in its February municipal opinion.
Meanwhile, the retail market is trying to move past the aftermath of Whitney’s damaging predictions.
“The municipal fundamentals are getting better — not worse — and state tax collections in the fourth quarter were among the highest in many years,” Parish said. “I think that will work in favor of municipal budget planners and convince investors the risks are not as great as they were perceived to be earlier this year.”
Some market participants have criticized Whitney for being irresponsible, and the media for holding her in such high regard.
Whitney has not returned calls from The Bond Buyer seeking comment.
“We all know there are problems, but the kind of cataclysmic event she is specifically calling for is the kind of extreme viewpoint a lot of large institutional investors do not agree with,” Mier said.
“If you are going to get on TV someone should hold you to the fire, and you should be compelled to discuss your reasons and give up some of the names you think will default,” he added.
“While it is important to acknowledge the budget problems that some issuers are having,” said David Lerner’s Mason, “it is irresponsible to make blanket statements and to totally ignore the uniqueness of different issuers.”
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