Lessons From the Muni-Bond Sell-Off
They're neither new nor novel.
It's been an awful time for the municipal-bond world during the past several months, with one headline after another causing investors to question their faith in the once nearly gilt-edged market. Morningstar's Miriam Sjoblom has been following those developments closely, and there's ample reason to believe there's a lot more smoke billowing than fire burning.
While clearly painful for many investors, the sell-off that gripped the market from early November to late January carried some important warnings that had very little to do with the mania and fears of imminent waves of defaults.
The first was an old one that seemed to elude many muni investors, based on the number who began to flee only after the trouble began.
Despite all the muni-market hubbub, the majority of pain felt by investors across the market was driven by a good old-fashioned spike in Treasury yields. Although the much-publicized muni-market warnings of Wall Street analyst Meredith Whitney on 60 Minutes chafed the market in December, the sell-off actually started earlier thanks to increasing worry about the effect of the Federal Reserve's so-called QE2 program. Shorthand for a second round of "quantitative easing," the Fed telegraphed its intent to continue purchasing bonds in the open market with hopes of sparking growth--and some inflation.
That news quickly changed market expectations for the latter, and Treasury bonds sold off. Bellwether 10- and 30-year U.S. Treasury bonds tumbled 5.4% and 8.2%, respectively, from November through January according to Barclays Capital, and that put pressure on the muni market. The average long-term national muni fund fell 5.9%.
Of the 15 muni funds with the worst losses between Nov. 1, 2010, and Jan. 31, 2011, that also boast assets of more than $1 billion, nearly every one carried a duration meaningfully longer than those of its comparable peer groups or indexes. They included flagship investment-grade funds such as Oppenheimer AMT-Free Municipals (OPTAX), Eaton Vance National Municipal Income (EANAX), and Lord Abbett National Tax-Free Income (LANSX), with losses ranging from 7.5% to 11.8% for that stretch.
On Borrowed Bond
In a handful of those cases, the funds' long-maturity profiles were helped along by a dose of leverage. Very few have been using portfolio-level borrowing or off-balance-sheet derivatives such as futures, forwards, and swaps, all of which have become popular among taxable-bond funds. The most common use of leverage in muni funds involves an inverse floating-rate bond structure called a Tender Option Bond trust. TOBs allow funds to borrow money at very short-term, tax-free rates and invest the proceeds in long-maturity bonds with much higher yields, pocketing the difference.
Using TOBs isn't necessarily as risky as investing in other, more esoteric derivatives, but they can expose funds to the whims of crowds using TOBs with the same bonds in their own portfolios. That caused trouble in 2008, when heavily leveraged investors--including many hedge funds--unwound their TOBs and dumped their bonds, pushing prices down well below what fundamentals and cash flows suggested they were worth.
That scenario is less likely today given how much less leverage is in the system, but simply using TOBs to generate extra income--and by definition, ramp up interest-rate risk--can subject a portfolio to plenty of volatility. Several of the aforementioned funds with long durations use TOB-based leverage to help them get there. They include numerous Oppenheimer Rochester funds and those run by Eaton Vance and Lord Abbett. Their overall leverage ratios ranged from between 108% and 123% before the sell-off; in each case the amount over 100% roughly corresponds to the percentage equivalent of their net assets that has been borrowed--and added to the portfolio--to invest in more bonds.
Several of the funds worst hit during the November to January period also hold lots of credit-sensitive bonds. In most cases, though, their particular credit risks have very little to do with the kind of public-sector debt concerns about which Whitney and others have been talking. Most of them are mid- and lower-quality issues--often carrying no third-party ratings--spread across a variety of sectors that have nothing to do with the day-to-day functioning of municipal services.
Highly represented in this group are bonds issued by states, but backed by revenues the tobacco industry agreed to fork over as part of a so-called Master Settlement Agreement back in the late 1990s. The difficult-to-gauge long-term risks that litigation, smoking laws, or changing smoking patterns could slash bond payments all combine to make the sector volatile, even in the best of times.
Several funds hold bonds backed by hospitals and health-care systems, airlines or other corporate backers, and continuing-care retirement communities, the second and third of which are much more sensitive to the health of the national economy and housing markets, respectively--and have almost no sensitivity to conventional state and local municipal finances.
The Oppenheimer Rochester funds have historically favored tobacco, (between 15% and 23%), airlines (between 9% and 17%), and nonrated bonds (between 20% and 40%). On the other hand, Nuveen and Goldman Sachs' high-yield muni funds have a particular taste for health care (22% and 21%, respectively), though the former is a much bigger player in the nonrated space (47%) than is Goldman's fund (20%).
Beware Thy Neighbor
The mix of credit-sensitive and nonrated bonds contributed some of the volatility suffered by this group, but the effect was not universal. Data from Barclays Capital suggests, for example, that while lower-quality muni yields' spread wider than their usual gap with high-quality munis a few times during the sell-off, they didn't travel very far on average.
What appeared to have a more meaningful impact in several cases were investors pulling their money out of funds over the course of the sell-off, and in some cases both before and after. The two funds with the worst losses during the November to January stretch, Oppenheimer AMT-Free Municipals (down 11.8%) and Eaton Vance National Municipal Income (down 11.4%), each suffered outflows of more than 15% of their assets during that same period according to Morningstar estimates.
Although not every fund with nonrated bonds and outflows found itself struggling, it's clear that some had difficulty coping. The damage wasn't limited to those two families, either. Among funds with at least $1 billion in assets that also lost more than 7.5% during the sell-off, Nuveen High Yield Municipal (NHMAX), Goldman Sachs High Yield Muni (GHYAX), Lord Abbett High Yield Municipal (HYMAX), Lord Abbett National Tax-Free Income (LANSX), and Hartford Municipal Opportunities (HHMAX) each endured outflows of between 12% and 17% of their assets during that three-month stretch, according to Morningstar estimates.
Unfortunately, there's little that any shareholder can do to specifically avoid the problem of having other investors pull their money out of funds in a hurry. The problems felt by muni portfolios during this sell-off, however, pretty clearly congregate around those that have chosen to take on significantly more--and more kinds of--risk than the average long-term muni portfolio. It's a tried and true reminder to those who would do so in the pursuit of more income: The lunch may be awfully enticing, but it's almost never free.
Miriam Sjoblom, associate director of fund analysis, co-authored this column.
Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.