Municipal Bond Funds: The Involuntary Move Toward Risk

Municipal bond fund inflows in 2019 were tremendous. In fact, they set an annual record of $95 billion through Dec. 31 into open-end mutual funds and exchange-traded funds, as illustrated in the chart below. This is 34% higher than in 2009, which held the previous record of $71 billion. A much smaller segment of the municipal bond fund market is high yield (or sub-investment grade). This segment also had a record-setting year, pulling in $18 billion of net flows, 61% higher than the last record set in 2012.

(Click on image to enlarge)

Muni bond funds

Source: Morningstar Direct

What’s fueling the muni-bond frenzy?

This influx of flows can largely be explained by strong technical demand, which in turn was driven by:

  • Continued economic growth
    Driven by the U.S. consumer and low unemployment.
     
  • Concerns about declining credit fundamentals and increasing default rates in corporate bonds
    Municipals are often used as substitutes for taxable corporate bonds, and concerns are rising about increasing leverage on corporate balance sheets.
     
  • Tax Cut and Jobs Act of 2017
    Beginning in 2018, tax reform eliminated benefits of refinancing debt for muni-bond issuers, which contributed to a reduced supply of new tax-exempt issuance in the ensuing two years. Concern over decreased supply—along with reduced mortgage interest expense deductibility—spurred demand, pushing muni yields lower and credit spreads tighter while boosting returns.
     
  • Elevated equity market levels
    Municipals (including high yield municipal debt) are considered a safe-haven asset class. As equity indexes continue to set record levels, investors may seek out asset classes that protect on the downside while still providing some amount of yield and return. Allocations to equities and bonds typically have outperformed equities and cash during market pullbacks, as evidenced in the chart below.

    (Click on image to enlarge)

Benefit of bonds
Source: Morningstar; U.S. Equities: S&P 500; Fixed Income: Bloomberg Barclays US Aggregate Bond; Cash: FTSE Treasury Bill 3 Mo Index. I
ndex returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. 

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