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Mutual Funds

Budget uncertainty has muni investors spooked

Municipal bonds continue to provide a reliable refuge from stock market volatility and a steady source of tax-free income.

An index of muni bond mutual funds has recently been yielding around 2.18 percent. While that’s nothing to brag about, it’s a substantially higher yield than the roughly 2 percent that 10-year Treasury bonds offer, without factoring in the tax-exempt advantage that munis offer.

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What’s more, muni bond fund performance has recently been solid, as is typically the case with steady-as-it-goes munis. Funds investing in intermediate-term bonds issued from a variety of municipalities nationwide had returned about 0.7 percent through late May, according to Morningstar.

But for all of munis’ stability, investors have clearly been scared the past several weeks. While other mutual fund categories have consistently attracted new cash, investors have been pulling money out of muni bond funds. During the five-week period ended May 15, withdrawals exceeded deposits, with a net $171 million flowing out, according to the Investment Company Institute.

Although that’s a tiny amount relative to the nearly $590 billion in muni fund assets, April wasn’t the only recent month when investors pulled cash out. Net withdrawals totaled about $294 million in March, and more than $3.1 billion in December.

Muni investors’ eyes are on Washington, as the White House and Congress chip away at the nation’s fiscal problems. Investors, particularly those in the top tax brackets, fear a budget proposal by President Obama that would cap the amount of muni bond income that an individual can claim as exempt from federal taxes. If Congress accepts Obama’s proposal — something highly uncertain in this fiercely partisan environment — the tax-exempt benefit would be capped at 28 percent for the top 2 percent of earners.

For example, someone in the top 39.6 percent bracket who paid zero federal taxes previously on $100,000 in muni income would pay $11,600 under Obama’s proposal. The $11,600 represents the difference between having none of the 39.6 percent tax rate apply on muni income versus capping the exemption at 28 percent.

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Under current law, munis are also free of state taxes if they limit investments to the state where you live. So consider whether munis’ tax advantages will offset the higher pretax returns you’d normally expect from investing in a taxable bond fund. Look at tax-equivalent yield. It tells how big of a return you’d need from a taxable investment to equal the return of a tax-free bond.

Jim Colby is keeping a close eye on the tax issue as a muni strategist with money manager Van Eck Global. He also manages a group of five exchange-traded funds that track muni bond fund indexes, using the Market Vectors brand name.

Colby discussed the recent muni market developments in an interview. Here are excerpts:

How do you explain the recent flow of cash out of muni funds, despite the solid fundamentals in the market?

Over the last several weeks, and the last few years, it’s become clear that the muni market is subject to ‘‘headline’’ risk. That’s in part due to the fact that individuals are the chief investors in muni bond funds. News developments can be critical in influencing what they do with their money. Munis are complex, in the sense that local and national politics can have a significant impact, as can commentaries from people who are able to grab headlines.

What specific factors are behind the recent flow out of muni bond funds?

We had a presidential election where the issue of the tax exemption on muni income was on the table. And during the fiscal cliff negotiations in December, nobody really had a handle on whether drastic legislation might pass. But there was enough talk to push muni investors to the sidelines, where they pulled cash out. In April, there are often seasonal factors in play, as some investors liquidate their muni holdings to pay annual tax bills. But that has not been as big a factor in recent weeks as the Obama administration’s budget.

What outcome do you expect from the budget negotiations between the president and Congress over the tax exemption issue?

You’d think they’d hammer out a compromise. The fear is that the tax exemption becomes a pawn in the negotiations, and maybe it falls into an agreement where one party can’t back out of a position it has staked out in the talks.

Should muni investors in the top income brackets be worried?

Munis have been a stable asset class historically, and they continue to be so, regardless of how the exemption issue will be resolved. Municipalities are generally in good financial shape, with tax collections rising. And even if the muni exemption is capped for top earners, munis still offer attractive tax-equivalent yields. You’ve still got a margin over corporate bonds or Treasurys.

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