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The meltdown in munis is a yield bonanza
Their growing returns are even more attractive because they're tax-free. The flip side is that the cities and states issuing bonds are in sorry shape. Choose your muni fund wisely.
By Timothy Middleton
Investors desperate for yield can find it in municipal bond funds. It just takes some careful exploration.
The yield on a Triple A insured 10-year municipal credit is in the 3.8% range, says Kenneth Salinger, manager of American Century Tax-Free Bond Fund (TWTIX). For an investor in the top tax bracket, thats the same as earning 6.29%. Treasurys of the same maturity are yielding 3.875%.
But there's a worrisome reason for those fat yields. Bond yields rise when prices fall. And prices have been battered by deteriorating finances and outright collapses in tobacco- and airline-backed bonds. So the total return of the typical municipal bond fund this year through April 9 was a minuscule 0.39%. Many, especially in California and New Jersey, are losing money.
Credit downgrades have outpaced upgrades by pretty significant margins for the last two years, says Steve Murphy, managing director for state and local government ratings at Standard & Poors. Ten states are currently on S&P's CreditWatch with negative outlooks, foreshadowing further downgrades. Weve had a perfect storm for state finances, Murphy says.
But storms create opportunities. Conservative investors will be drawn to the steadiest funds that, even in this market, do the best job of preserving shareholders capital. Speculators will be drawn the opposite way, to tax-free funds that bargain-hunt for the most distressed issues.
Skipping the good and the bad
If you like the look of municipal bonds, your taste runs to ugly. The bear market in equities has sucked hundreds of billions out of taxes, and recession has slashed revenues further. At the same time, Medicaid and other health-care costs are rising in double digits.
Something similar happened in the late 1980s and early 1990s, but then states and localities were bailed out by a recovering housing market, boosting property taxes, and a big increase in car sales, boosting sales taxes. No such prospect is on the horizon now.
In fact, the prospect now is glum. This time around, state and local governments are saddled with souring investments in tobacco and airlines.
| Funds with big tobacco exposure | | Fund | Exposure | | Oppenheimer NJ Muni | 17% | | Lebenthal NJ Muni | 8.8 | | Oppenheimer CA Muni | 8.1 | | Smith Barney Managed Muni | 7.6 | | Smith Barney NJ Muni | 6.3 | | Goldman Sachs High Yield Muni | 5.8 | | Smith Barney CA Muni | 5.1 | | Lebenthal NY Muni | 4.6 | | Alliance Muni Natl | 4.2 |
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Notes: Percentage of funds top 5 (state-only) or 10 (national) holdings in tobacco settlement bonds.
Portfolio data from varying periods, Jan. 31 or earlier.
Source: Standard & Poors
The fear alone has been devastating. Oppenheimer California Municipal (OPCAX) and Oppenheimer New Jersey Municipal (ONJAX) each shed more than 1% of their value on a single day, March 31. As of April 9, the California fund was down 5% for the year to date, and the New Jersey was down 5.6%.
I have to plead guilty to misjudging the woes of both the tobacco and the airline mess, says Ron Fielding, chief strategist for Oppenheimers tax-free portfolios. As recently as one month ago, one of his big positions, bonds issued by the Dallas/Forth Worth airport authority, was changing hands at 12 cents on the dollar.
They have since rebounded to 50 cents, he says, and are due to mature Nov. 1 at par. If American Airlines (AMR, news, msgs) stays out of bankruptcy until then, we will get 100 cents on the dollar, he says.
Screening for safety
But most municipal-bond investors would find that cold comfort.
If youre investing in fixed income, youre looking for capital preservation, says Michael Pietronico, co-manager of Evergreen Offit California Municipal Fund (EOCIX), which eschews risky bonds and is ahead this year, albeit only by 0.3%. If theres any risk investors should be taking with their portfolios, it should be on the equity side.
But determining the level of risk in a municipal bond portfolio isnt easy. Unless they target the high-yield end of the spectrum -- and the funds that do have suffered the most in the current debacle -- muni bond funds tend to own enough high-quality bonds to give the total portfolio a high, and often a Triple A, credit rating.
Lebenthal N.J. Municipal Fund (no ticker), despite its cigarette habit, has the same Triple A rating as the Evergreen fund, but is down 0.54% this year.
One way to tame risk is to buy a fund with very low price volatility. Identifying such funds can be made easier with MSN Moneys Fund Screener, which can identify portfolios with a combination of low volatility, or price swings, and high returns. Here's a screen of national intermediate-term municipal bond funds. It can be altered to search for state-only funds by changing that value appropriately.
The hard work
But picking the best muni fund is a multidimensional job, and in the end, it comes down to doing your homework. One of the best long-term national muni funds, as ranked by Morningstar, is Harris Insight Tax-Exempt Bond (HXBIX).
It doesnt show up on our screen because its volatility, or standard deviation, is a relatively high 5.33%. It also doesnt appear because we screened for intermediate-term funds, which are usually the best bet for investors, offering most of the returns of long bonds with less risk.
But Harris is the exception that proves the rule. It's managed very conservatively, but takes advantage of its managements research acumen to pick individual issues adroitly.
The municipal market is really inefficient, says manager George Selby, so theres a lot of supply and demand dynamics were able to take advantage of. States tend to issue bonds all at the same, pushing down their prices, and Harris buys heavily at such times, then sells as supply weakens and prices rise.
So funds such as Harris and those our screener uncovers could be termed strategic funds, suitable for holding for long periods. Riskier funds are tactical weapons, suitable for speculators who want to place bets that tobacco and airline bonds will bounce back.
Will Philip Morris pull through?
Oppenheimers Fielding insists it will. Part of the master settlement agreement provided for states to enact legislation, which they did, that stops tobacco companies from selling their products if they fail to meet their payments. We believe that, just like the airlines, which must have gates, Philip Morris will make payments even if its in bankruptcy, he says.
So bond investors can give themselves a tax cut today by switching from federal to local government bond funds. Even if interest rates begin to rise, as many bond investors fear, the impact will be less on municipal bonds because they have already been depressed by events.
This subject is only of interest, of course, to taxable investors. Corporate 401(k) plans dont offer tax-free bonds, and IRAs shouldn't, because their participants are already shielded from current taxes and therefore benefit more from taxable bonds.
But in those taxable accounts, nearly every fixed-income investor stands to benefit from munis now.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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