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Retail investors seen piling into muni debt

SAN FRANCISCO (Reuters) - Individual investors scooped up municipal bonds in the first quarter and demand for the debt will remain healthy over the near term despite the gloom hanging over state and local finances, analysts say.

Demand was evident in the first-quarter’s big finish, with the issuance of about $12 billion (8 billion pounds) in debt, including a massive California deal, in the final week. That was the strongest weekly issuance total since December 2006, according to a Savader Asset Advisors report.

After the market’s “deep freeze” late last year, “municipal volume expanded during the quarter, indicating a growing acceptance among investors for municipal debt,” said the report, released on Monday.

California in particular rode the wave of revived interest among individual investors for municipal debt, culminating with its sale last month of more than $6 billion in tax-exempt bonds.

State Treasurer Bill Lockyer had planned to sell $4 billion of debt in his first sale of general obligation bonds in the municipal market since mid-2008. But after individual investors nabbed $3.2 billion of the bonds, he increased the sale’s size and reaped $6.54 billion in total orders.

The tally was all the more striking as it followed cuts by Fitch Ratings and Moody’s Investors Service to their ratings on California’s general obligation bonds amid headline news of the state’s weak finances.

Retail investors also piled into the broader municipal debt market during the first quarter by way of mutual funds. They posted a net inflow of $13.9 billion last quarter, according to AMG Data Services of Arcata, California.

“That was the largest (quarter-on-quarter) net inflow into municipal bond funds on record,” said Robert Adler, AMG Data’s president.

SEEDING INFLATION

The rush proved rewarding for retail investors who bought into municipal bond mutual funds, said Jeff Tjornehoj, an analyst at Lipper, a Thomson Reuters company that tracks mutual funds. “They got in three months better returns than they typically get in a full year.

“We’re looking at quarterly performance at muni bond funds of 4 percent to 7 percent returns,” Tjornehoj said. “That’s cleaning up.”

Those returns are expected to bolster retail demand for municipal bonds while their tax-free status should help offset concerns about state and local finances. Public finances are strained across the United States as tax and revenue are hit by the recession.

Munis also look attractive compared with U.S. Treasury debt, which is offering low yields.

“There is a flight to quality and when you look at a flight to quality, munis are a great investment,” said Katie Carroll, a deputy California treasurer.

“On a relative basis the returns are attractive and the risks are very low,” added Eric Friedland, director of research at Belle Haven Investments in White Plains, New York. “Not only that, if tax rates go up, as many expect they will, muni bonds become more attractive.”

Municipal debt also looks attractive with inflation concerns muted. But municipal bond investors should keep a close watch for inflation’s return.

“If somebody is going long to maximize their yield, they could well regret that,” said Tom Hepner, an investment adviser at Ruggie Wealth Management Inc in Tavares, Florida.

First Trust Advisors Chief Economist Brian Wesbury said the Federal Reserve’s efforts to prop up the economy and revive credit markets amid the worst U.S. financial crisis since World War Two have set the stage for a resurgence of inflation.

The authorities have pumped over a $1 trillion into the economy and lowered interest rates almost to zero.

“Eventually the Fed will have to push up rates and then bond holders will pay a price,” Wesbury said. “Investors in municipal bonds are underestimating inflation.

“I still encourage investors to be in that three-to-five year range,” he said. “In fixed income I want to stay short. The credit risk is being rewarded but the inflation risk is not.”

Editing by Dan Grebler

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