Hospitals getting ready to issue bonds often ask their bankers and advisers what drives rates in the municipal bond markets. While there are a number of supply and demand factors that can impact rates, experts say fund flow is not one of them.

Hospitals want to know where interest rates are headed, so bankers and financial advisers are routinely asked what could cause the MMD index to go up or down in the near future.

Some can be heard saying that the MMD is impacted by bond fund flows.

Fund flows represent the dollar amount that investors put in or take out of municipal bond funds over a given period of time.

Funds meet outflows by selling bonds, which increases supply; the opposite is true of inflows which require bond funds to buy bonds and decreases supply (or increases demand, depending on how one looks at it).

Supply and demand theory would dictate that when muni funds experience outflows, rates go up; when funds experience inflows, rates go down.

A quick look at fund flows and rates since 2009 does show a pattern of rates climbing when funds experience outflows.


But there is a lot more to it.

First, the relationship between MMD and fund flows is relatively weak: regression analysis shows a coefficient of determination or “R-squared” of only 20%, whereas perfect correlation would be 100%.

Second, the question is: does the MMD change in response to fund flows, or is it fund flows that change in response to the MMD?

Brian Reid, chief economist with the Investment Company Institute (ICI, the national association of mutual funds), says it’s the latter: interest rates drive bond flows, not the other way around.

Reid says that’s because fund flows represent less than 10% of primary dealer trading, so flows are too small to influence rates.

Robert Ciccarone, head of Merritt Research (the company behind CreditScope), agrees with Reid that interest rates influence fund flows: when interest rates fall on the long end, funds experience inflows.

Some bankers still argue that while fund flows may not be the main driver behind the MMD, they can still impact how MMD trades against Treasury yields.

But the analysis shows virtually zero correlation between fund flows and how the MMD trades relative to Treasurys.

So changes in tax-exempt interest rates can be blamed on a number of market factors, but fund flows is probably not one of them.