NEW YORK -- Municipal bonds are getting another chance.
Money is flowing once again into muni-bond mutual funds, a turnaround from last year's exodus. So far, investors have been rewarded for renewing their interest, but managers caution that several challenges remain.
It's just the latest turning point for an industry that has experienced many of them in recent years. In late 2010, investors stampeded out of muni-bond funds following a prediction that a wave of defaults would hit the market. The wave didn't materialize, and buyers returned. Last year, investors ran once again. The worries started in the spring when interest rates began rising and intensified after Detroit filed for bankruptcy.
The turn of the calendar brought a trickle of money back into muni-bond funds. Investors deposited a net $342 million in January, according to the Investment Company Institute. That's a drip compared with the nearly $10 billion that flowed out of muni-bond funds in December, though the pace has since picked up. About $1.4 billion came in the four weeks through Feb. 26.
Those investors who jumped in early profited: Municipal bonds have returned 3.2 percent this year, according to the Barclays Municipal Bond index. It's a sharp turnaround from the index's drop of 2.6 percent in 2013, its worst loss since 1994.
"It's unrealistic to think we can continue this pace that the first two months have had," says Rick Taormina, head of tax-aware strategies at J.P. Morgan Funds. "Really, it's almost mathematically impossible."
But before getting into why, here's a reminder of what municipal bonds are and what kinds of investors they tend to attract: Municipal bonds are issued by water and sewer authorities, cities and other local governments. The income that they produce is generally free from federal income taxes and sometimes from state and local income taxes.
The tax exemption means municipal bonds tend to attract investors in high tax brackets. Top federal tax rates have also risen in recent years -- as much as 39.6 percent last year from 35 percent in 2012 -- which makes the exemption even more valuable. Tax-exempt muni bonds are also most suited for an investor's taxable account. Putting them in a 401(k), individual retirement account or other tax-deferred retirement account would negate their big advantage.
This year's gains have come for a couple reasons. Chief among them is that interest rates have dropped, and falling rates push up bond prices. The yield on the 10-year Treasury note has sunk to about 2.73 percent from 3 percent in early January.
When interest rates fall, all types of municipal bonds benefit, particularly long-term bonds. That's because investors are locked into their yields for a longer period, yields that suddenly look better than they did at the start of the year. The average long-term national municipal bond fund has returned 3.7 percent this year, compared with 0.9 percent for short-term national municipal bond funds, according to Morningstar.
But many strategists don't expect rates to continue to decline. The economy is improving slowly, recent hiccups related to bad weather notwithstanding, and that should put upward pressure on interest rates.
Given that, and other factors, J.P. Morgan's Taormina says investors shouldn't be surprised to see the recent jump in gains for muni-bond funds plateau, possibly with a break-even return for the rest of the year.
Muni bonds are compelling relative to other investments, he says. "But I think there will be plenty of dips through the year" during which losses for muni bonds will offer buying opportunities for investors.
Besides rising interest rates, here are some of the other concerns that could limit muni-bond returns:
Detroit's bankruptcy last year got a lot of attention, but managers of muni-bond funds say they're hearing more questions now from investors about Puerto Rico. The territory has a smaller population thank Oklahoma, but it has an outsized role in the muni-bond market.
Income from its bonds is tax-free for residents in other states, which made them particularly attractive to investors in New York and other high-tax states. Such demand allowed Puerto Rico to issue a lot of debt: It has almost $50 billion in municipal debt outstanding, according to T. Rowe Price. Fiscal problems in Puerto Rico, though, pushed credit-rating agencies to cut its rating to junk status this year.
But muni-bond fund managers say the larger market is nevertheless improving. The default rate for municipal bonds remains below 1 percent. Local governments have gotten a better handle on their pension problems, and tax revenues have strengthened.
What about the tax exemption?
Congress is debating whether to strip away, or at least reduce, one of the big advantages of muni bonds: their tax-exempt income. If the proposals turn into law, it could drive down demand for municipal bonds. Local government officials are lobbying against the proposals, saying they would make borrowing more expensive to pay for roads and other infrastructure projects.
But fund managers say they've seen similar threats many times before, which ended up fizzling, and they don't see this attempt as any more dire.
"The income tax is 100 years old, it goes back to 1913, and ever since then there have been people in Washington looking to take it away," says Gene Gard, a co-portfolio manager of Dupree Mutual Funds, which invests about $1.3 billion in municipal bonds. "It could happen someday, but we're not going to take steps to worry about it until something concrete happens."