Attraction of munis drops for investors

BOSTON - It wasn't long ago that municipal bond funds provided a reliable refuge from stock market volatility. Investors could expect steady returns of 4 percent to 5 percent a year.

The appeal of muni bonds is that their interest payments are exempt from federal taxes and most state and local taxes. Although this safe-haven approach won't make anyone rich, it can provide a decent return. That's especially true for investors in high tax brackets.

Another selling point for investors is that municipal bonds help communities grow. Munis are essentially IOUs issued by state and local governments to fund projects such as building schools, hospitals, roads, and bridges.

But investors seem to have forgotten munis' best features lately.

They've stampeded out of muni bond funds, withdrawing a net $45 billion in the last six months, according to fund tracker Morningstar. That's about 9 percent of the assets these mutual funds held last fall.

Investment returns have also been uncharacteristically volatile. Muni bond funds fell an average 4.6 percent in the last three months of 2010, their worst quarter since 1994.

Trying to make sense of it all is Natalie Cohen, who directs municipal research at Wells Fargo Securities. In an interview, Cohen discussed the changes, and how muni investors can navigate them. Here is an excerpt.

Question: Besides the fears about the financial troubles of their local governments, what factors have been driving investors away from munis?

Answer: Recent withdrawals followed a period when money flowed in during the financial crisis, during a flight to safety. Munis' tax protection looked attractive when the government was busy with stimulus programs and bailouts.

Then in December we saw the end of Build America Bonds [a stimulus program that provided federal subsidies to encourage construction of roads and other local projects]. That program brought new buyers into the muni market who traditionally weren't drawn to it because they're already tax-exempt. Pension funds are an example. That program kept muni yields artificially low and prices high.

Now that the program has expired, it's pressured the muni market, and bonds dropped in value late last year.

Q: Investors began pulling out of munis just after the November midterm election. Was there a connection?

A: Republicans made gains in Congress and in governors' offices and vowed to reduce spending. That put more attention on the health of state and municipal finances.

Then Congress agreed in December to extend the Bush tax cuts. That made munis' tax protection less appealing, and investors went elsewhere.

Q: What's going on now?

A: We're starting to see small amounts of money moving back into muni bond funds. There was a rally that started in mid-April. People looked at reports showing state revenues were improving.

Hopefully, price volatility will ease in the second half of the year.