July 16, 2021

Factors Influencing Capital Inflows for Tax-Exempt Municipal Bond Funds

by Jack Fischer.

Tax-exempt municipal bond funds (including both conventional funds and ETFs) have recorded 19 straight weeks of estimated net inflows. The asset class has witnessed only one week of outflows this year during the first week of March. That same week we saw daily sessions where the two-year yield rose more than 30.0% and the 10-year yield spiked nearly 10.0%. Money market funds attracted $23.6 billion over that Lipper fund-flows week, and the VIX ended at 28.43 (currently around 17.01)—safe to say uncertainty was more abundant in the market at the time.

The first week in March aside, tax-exempt municipal bond funds have recorded weekly inflows of more than $1 billion in 70.4% of the weeks this year. The reported first half inflows of $56.9 billion is a record-setting figure, nearly $10 billion more than the previous six-month high set in 2019. Their first-half total inflows total would rank third all-time in year-end inflows. Inflows during 2020 most likely would have been in the top five for calendar year inflows if it wasn’t for the $46.1 billion of March outflows during the onset of the pandemic. What has made the tax-exempt muni bond funds so attractive?

Quarterly Flows Lipper Muni Funds

The answer has plenty of variables that stem from the general characteristics of tax-exempt municipal bonds to how monetary and fiscal policies have been playing out. Municipal bonds have benefitted from yield-seeking investors who have seen high-yield and investment-grade credit spreads tighten to multi-year lows over the past year. Lipper High Yield Muni Debt Funds attracted their top six historical weekly inflows during the 2021 campaign and have set a record in Q2 for the largest total net inflows. Both low-forecasted default rates and a more-than-likely infrastructure plan will continue to spotlight the asset class. While the Build America Bond program in 2009, through President Barrack Obama’s American Recovery and Reinvestment Act, certainly focused on taxable municipal bonds, 2009 ended up being the second-largest annual intake on record for tax-exempt muni bond funds (+$81.1 billion). Any infrastructure spending put in place by President Joe Biden, whether focused on taxable or tax-exempt muni funds, should continue to improve the creditworthiness and attractiveness for both types.

Another tailwind for tax-exempt municipal bond funds since the start of the year has been the possibility of a higher corporate and individual tax rate. As tax rates go up so does the tax-equivalent yield, a standard metric for determining the opportunity cost of investing in a taxable corporate bond of similar risk and credit profile. Since interest is not taxable for tax-exempt municipal bonds, investors are willing to accept a lower yield. For example, between 2012 and 2013 the highest tax bracket increased from 35.0% to 39.6%. An investor looking to buy a tax-exempt municipal bond yielding 3.0% would have gone from needing to be compensated 4.6% in 2012 to 5.0% in 2013. The threat of higher taxes alone is enough to increase flows into municipal bond funds. The year 2012 ranked fourth highest in calendar year inflows for the asset class.

Another core selling point to hold municipal bond funds within your larger portfolio has been their historically low correlations to equity markets. Whether the market is overvalued or undervalued, a central philosophy for a lot of investors is diversification. The low three- and five-year correlations between the returns of tax-exempt municipal bond funds to broad-based U.S. indices provides a nice added benefit to compliment a balanced portfolio.

Lipper Muni Correlation to Equity MarketsIn 2019, the focus was Lipper Short Muni Debt Funds. In the past few years, a search for yield and longer-dated tax-exempt municipal debt funds have caught the eye of the market. Performance has not hindered the Lipper general municipal debt funds either. Lipper High Yield Muni Debt Funds and Lipper General & Insured Muni Debt Funds recorded stellar trailing one-year performance—11.15% and 5.97%, respectively. Lipper High Yield Muni Debt funds led all tax-exempt fixed income funds in trailing one-year performance and finished behind only three taxable Lipper fixed income classifications.

Attribution of Lipper Muni Annual Flows by Classification

With higher taxes on the horizon and municipal credit concerns diminishing due to reopenings and potential infrastructure spending, Lipper tax-exempt funds are poised to continue their inflow streak. An astonishing $129.8 billion has left money market funds over the last six weeks and will have to find a home eventually.

Check out this week’s fund flow trends here!

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