According to a report released by New York-based Strategic Insight on Thursday morning, investors put $30 billion into stock and bond mutual funds in February. Read the Strategic Insight report.

For the first quarter of 2010, net inflows to stock and bond funds could top $100 billion, a big reversal from the less than $10 billion garnered in the year-ago period.

But where are investors putting money to work, specifically?

It’s all about fixed income products.

Loren Fox, Strategic Insight’s senior research analyst, says that, with money-market funds and deposit accounts continuing to offer near-zero yields, investors are hungry for income alternatives.

In total, they put $24 billion into bond funds in February. Leading the inflows, says Fox, were short- and intermediate-maturity corporate bond funds, with $10 billion in combined net inflows.

Global bond funds captured more than $4 billion in the latest month, he says, while inflation jitters encouraged inflows of $2.5 billion to TIPS funds.

Enthusiasm for bond funds mirrors trends that unfolded last year. Full-year 2009 inflows to bond funds — including traditional mutual funds and ETFs — reached an all-time record of $396 billion.

The massive inflows into bond funds will continue into 2010, says Fox.

“Interest rates will not rise significantly this year,” he says. “So money market funds and bank deposit accounts will continue to be not all that attractive from a yield point of view.”
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“There are two trends at work here,” says Fox. “Investors for many years now have been increasing the global diversification of their portfolios. Also, international markets have done better than the U.S. equity markets. So that has emboldened investors to put more money into international funds.”

However, in contrast to bond funds and international equity funds, investors showed little love for the home team.

Flows into diversified U.S. equity funds were negative in February, says Fox, despite the average domestic equity fund delivering a 3.4% total return in the month and nearly 60% return for the prior 12 months.
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But, despite this hard rally, a lot of investors seem to think U.S. stocks are a bad bet, given the uncertain path ahead for a fragile economy plagued by ongoing problems in housing, commercial real estate, and the labor market.

“We are not sure when investors will begin putting more money into equity funds,” Fox says. “They haven’t embraced stock funds because they do have lingering concerns about how this recovery will take shape.”
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How do financial advisers, who guide most investment decisions, feel about where to put money to work in the investment world?

According to a survey conducted by Charles Schwab in January, financial advisers intend to pull away from fixed income: 16% plan on investing more in bonds versus 25% in July.

But there wasn’t much cheerleading for U.S. stocks, either: 26% say they’ll invest more in large — cap U.S. stocks versus 30% in July.

Separately, and sort of interestingly, ETFs experienced $5 billion of aggregate net inflows during February, a reversal from the net redemptions seen in January. The biggest draws were U.S. equity ETFs like the SPY.

Why would investors withdraw money from U.S.-focused mutual funds, but commit capital to U.S. equity exchange-traded funds?

One reason, says Fox: Investors might be more comfortable slowly tip-toeing back into the market with relatively cheap, passive vehicles.

Still, investors need to weigh the risks of muni bonds. Rising interest rates could hurt bond prices across the board, and many states are wrestling with budget gaps in the recession due to falling tax revenue.

Muni bonds help states and localities pay for public projects such as education and transportation projects. With nearly $2 billion in assets, iShares S&P; National AMT-Free Municipal Bond Fund (MUB) is the largest muni-bond ETF. It was up 9.2% over the 12 months through March 11.

Low-fee ETFs allow investors to buy a basket of bonds in a single trade rather than researching and purchasing individual securities.

Hazard signs

“Storm clouds” are brewing over state and municipal governments, Morningstar said in a recent report.

“They’ve seen tax revenues decline just as the demands on their resources are increasing,” the report said. “California may be capturing all the headlines, but many other states have seen their financial conditions deteriorate.”

Rising interest rates are another big risk for municipal bonds, since bond prices and rates move in opposite directions. Investors concerned about higher interest rates can get some protection by moving into shorter-maturity bond ETFs.

Muni-bond prices plunged and yields surged in late 2008 when credit markets panicked. Muni bonds were hit by the collapse of dealers Bear Stearns and Lehman Brothers, coupled with the trouble in the auction-rate securities market and muni-bond insurers going out of business. The chaotic and illiquid market contributed to index tracking error in muni-bond ETFs at the time.

The so-called yield spread between munis and comparable Treasury bonds blew out to dramatic levels during the credit crunch. Part of the reason is that anxious investors piled into Treasurys for safety and pushed government-bond yields down.

With the introduction of government stimulus measures, those yield spreads snapped back as muni-bond prices rallied, giving investors a “once-in-a-generation-type year in 2009,” said Jim Colby, strategist at Van Eck Global, which offers a suite of muni-bond ETFs.

Despite the recovery, investors continue to worry about budget shortfalls, declining tax receipts and cuts in services. Still, investment-grade muni bonds have had extremely low historical default rates. Defaults do happen though; Orange County declaring bankruptcy in 1994 is one infamous example.

Tailwinds

There are some reasons to be optimistic about muni bonds even with the recession and their recent performance

Some investors are drawn to munis because the interest income is usually exempt from federal income taxes, and also from state taxes in some cases. Tax cuts passed during the Bush administration are set to expire at the end of 2010, which should make muni bonds even more attractive.

Munis usually have lower yields than comparable Treasury bonds, but the tax savings can compensate for the difference.

However, investors should keep an eye on a bill that was recently introduced by Sens. Ron Wyden, D-Ore., and Judd Gregg, R-N.H., that would eliminate key tax advantages of muni bonds.

Another factor working in favor of muni bonds is the Build America Bond program implemented by the Treasury Department last year. Build America Bonds are taxable bonds issued by state and local governments, while 35% of the interest income is rebated back to the issuer by the Treasury. The program is scheduled to expire at the end of 2010.

“The primary goal of the program was to reduce the cost to the issuing municipalities by offering higher rates (subsidized by the government) in order to draw in non-traditional buyers of municipal debt,” Morgan Stanley analysts wrote in a January research note.
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Choosing muni-bond ETFs

At the end of January, there were 27 muni-bond ETFs listed in the U.S. with a combined $6.2 billion in assets, according to Investment Company Institute.

Investment managers that oversee muni-bond ETFs include BlackRock, Grail Advisors, State Street Global Advisors, Invesco PowerShares, Van Eck and Pimco.

Some of the more-diversified options include Market Vectors Long Municipal Index ETF (MLN) , PowerShares Insured National Muni Bond (PZA) and SPDR Barclays Capital Municipal Bond (TFI) .

There are also ETFs targeting various maturities, and funds for individual states including California and New York.

We have heard of closed-end funds buying exchange-traded funds as part of their portfolio; it only makes sense. After all it is a fast way to invest in the market or a market segment quickly, cheaply and easily.

Turnabout is fair play, and ETF creators have come up with a twist, an ETF that buys closed-end funds. The PowerShares CEF Income Composite Portfolio ETF (PCEF) invests in income-producing closed-end funds that use three different investment approaches. The broad classes are investment-grade, non-investment-grade and buy-write option funds.

Investment-Grade Fixed Income Funds:

Investment-grade government and corporate bonds, mortgage-backed securities and preferred stock–these are securities rated equal to or higher than BBB. About 44% of funds are invested in this approach.

High-Yield Fixed-Income Funds:

Non-investment-grade bonds of corporations, banks or sovereign debt, rated below BBB. About 18% of funds are invested with this approach.

Covered call funds or buy-writes:

These closed-end funds buy common stocks and write call options on their position to generate income. About 38% of funds are invested in this class of funds.

The fund sponsors claim the benefit of the new ETF is that it offers diversification by asset class, investment strategy and investment manager. In addition to such diversification, the fund offers high current yield and a high discount to net asset value in its holdings.

The fund’s rules for investing include buying closed-end income funds that have a market cap of at least $100 million and an expense ratio of less than 2%; funds must trade at a premium of less than 20%.

PCEF will increase the weighing of certain funds as their discounts increase and will decrease weightings when the discounts shrink. The current makeup of the fund has an average discount of –4.17% and a yield of 8.59%.
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We like this ETF for the same reasons we like closed-end funds: the opportunity to buy $1 worth of stock for 90 cents. The fund is buying a significant portion of the closed-end income fund universe, giving the holder instant diversification.