Alert: The Hidden Risks That Might Be Lurking in Muni Bond Mutual Funds

Alert: The Hidden Risks That Might Be Lurking in Muni Bond Mutual Funds

If you invest in municipal bond mutual funds, some odd quirks about the way mutual funds work could have a big impact on your risk.

In 2021, money has been pouring into muni bond mutual funds and ETFs (likely in anticipation of higher taxes). I recently read a story Bloomberg ran on 9/30/2021, High-Yield Muni Funds Shed $103 Million, First Drop Since March1. Understanding that cash flows fluctuate week-to-week, I wondered if a change in trend was afoot. Two more cash flow articles recently appeared on my Bloomberg feed:

10/6/2021Muni Mutual Fund Inflows Decrease 61% to $704 Million: ICI.

ICI is our data source for reporting cash flows in municipal bond mutual funds and ETFs.

10/8/2021Municipal-Bond Fund Investor Pullback Signals Weakening Market.

“[Investors] pulled $344 million from long-term municipal-bond mutual funds and $460 million from high-yield funds during the week ended Wednesday, according to Refinitiv Lipper US Fund Flows data. Overall, they put just $37 million into municipal funds, the least since an outflow in March and down steeply from last week’s $408 million inflow.”

Why is this once-hot market starting to cool? Interest rates have been rising since 9/22/2021, and investors worry that the increase marks the start of a longer-term trend. If it does—and at this point, no one can say for sure—mutual funds could find themselves particularly vulnerable to interest rate risk in a way that separately managed accounts (SMAs) typically are not. That said, for small dollar investors who do not qualify for SMAs, mutual funds provide diversification that cannot be achieved in single muni investments.

Here’s the problem facing muni mutual fund investors:

  1. Less liquidity on the Street. Consolidation among Wall Street firms over the last 20 years means the market is more illiquid than ever. There are fewer firms, and they are committing less total risk capital. The growth in municipal bond tax-exempt mutual funds and ETFs is outpacing the risk capital that the Street has committed to this asset class, creating imbalances.  Just look at the supply/demand imbalance in the municipal bond market this year. At the end of August, on a YTD basis, new cash flowing into municipal bond mutual funds outstripped issuance of new municipal bonds by $50 billion. We find another example by examining the Fed's Financial Accounts of the United States Report, L.212 Municipal Securities section. In 2018, non-money market mutual funds were valued at $693.6 billion. Security brokers and dealers; municipal securities; assets were valued at $20.7 billion, a ratio of 33.5:1. Today, those values are $952.4 billion vs. and $10.7 billion, respectively—for a ratio of 89:1. Quite a difference. If rates go up, that means there is even less available capital to cover outflows.

    Why is this important to me? Early in my career, I worked at a mutual fund company that saw shareholder outflows from those municipal bond mutual funds during the ‘87 bond market crash of approximately 2% per day for ten days (if memory serves). Yes, that might have been a "Black Swan" event, but an experience like that stays with you.

  2. A potential rush for the exits. If this is a prolonged move to a more normal interest rate environment, shareholders in municipal bond mutual funds will fall into two categories, a) those who stay and b) those who flee. Both are interconnected. Those who flee will incur capital gains based on the share price when sold and the average cost of those shares. Those who stay will receive a capital gain distribution, in all probability, based on the assets the portfolio managers sell to fund the redemption of those who flee.
  3. The risk of a fire sale. What will portfolio managers sell to meet redemptions? Most, if not all, mutual funds have a layer of liquidity built into their portfolios. That liquidity layer is usually made up of short-maturity, highly liquid securities that typically do not yield much, especially in the current environment, but can be readily turned into cash to meet redemptions. One must wonder how many mutual fund portfolio managers succumbed to the temptation to run with lower reserves and longer maturities—and even bought lower credit quality securities—to achieve an attractive yield. Some mutual fund managers could come to regret those purchases.
How a portfolio manager decides to respond to higher redemptions will prove critical—especially if we enter a prolonged period of shareholder redemptions.

Most likely, the first move will be to use the liquidity layer to meet redemptions. If redemptions only last a short period, this is the right choice, in my estimation. As in the spring of 2020, before the Fed came in to support the markets, all should end well. The portfolio manager can take time to rebuild the liquidity layer.

If high redemptions continue, however, the portfolio manager has two choices.

  • Continue to sell the most liquid securities in the fund. This strategy favors fleeing shareholders, because the fund price at the end of the day will not be too adversely affected by the sales (as in life, it is always better to be the lead rat leaving a sinking ship).  But for shareholders who stay, the fund becomes less liquid and riskier.  And if outflows continue, each additional sale of assets to fund redemptions will make a bigger impact on the share price at the end of the day.  Why? As we mentioned, Street liquidity is a limited resource, and as it is used up, it will fetch a higher price. That higher price means lower relative bids for the increasingly riskier securities the mutual fund must sell to meet redemptions.

  • The other choice—the one I prefer—is to sell the average characteristics of the fund. Think maturity and credit quality. This strategy treats both shareholder classes in a similar fashion, and ensures those who stay in the funds do not end up with a riskier investment when the turmoil subsides.

Let's hope these scenarios never play out. But muni investors who own mutual funds instead of SMAs might want to exercise extra caution. In times like these, it’s good to remember the six Ps: Proper Planning Prevents Pitifully Poor Performance.


1 Woodhouse, Skylar. “High-Yield Muni Funds Shed $103 Million, First Drop Since March” Bloomberg, 9/30/2021
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