After sitting on the sidelines for two years, individual investors, long the driving force in the municipal bond market, began to shift assets into muni funds at a record clip in 2005. Despite asset outflows of $1 billion in November and December (in anticipation of higher interest rates and a surge in new issues), muni mutual funds took in $9.7 billion for the year as of December 21, according to Arcata, Californiabased AMG Data Services. During the same period in 2004, investors pulled a net $9.9 billion out of the funds.
But individual investors aren’t the only ones snapping up munis. Institutional investors other than municipal bond mutual funds -- most notably, hedge funds seeking to exploit the muni market’s pricing inefficiencies through leveraged strategies -- have been a growing presence. In fact, they help to explain a significant narrowing of spreads. About a half dozen hedge funds with a combined $3 billion in assets now focus on the municipal bond market, according to Randy Jacobus, a principal at Minnetonka, Minnesotabased Alternative Strategy Advisers (ASA), which runs three hedge funds that specialize in relative-value muni trading.
The lion’s share of the new assets flowing into muni mutual funds in 2005 -- roughly $8.1 billion worth through December 21 -- has gone into high-yield municipal bond funds. They are one of the few sources of incremental yield in the low-interest-rate environment of the past two years.
“Retail investors have been very discontented with the low yields on high-quality municipal bonds, so they have gravitated to the high-yield sector,” explains Walter O’Connor, manager of the $1.4 billion Merrill Lynch National Municipal Fund. “It’s also a case of money chasing performance.”
High-yield municipal bond funds have generated the highest total returns in the municipal bond fund category over the past year. The average high-yield municipal bond fund tracked by Morningstar is up 6.28 percent over the 12 months ended December 23, compared with a gain of 2.98 percent for the average long-maturity municipal bond fund.
With so much new money going into the high-yield sector, yields have declined. A year and a half ago, tobacco settlement bonds (bonds backed by the Master Settlement Agreement that requires tobacco companies to pay between $150 billion and $225 billion over 25 years to states as repayment for smoking-related health care costs) were yielding as much as 8 percent. That yield has since dropped to 4.50 percent, notes Merrill’s O’Connor.
In June 2003, O’Connor purchased Golden State Tobacco Securitization Corp.'s 7.88 percent bonds, due 2042 at a 7.80 percent yield. He sold the bonds in September, when their yield had dropped to 4 percent. Most other segments of the high-yield muni bond market have also seen credit spreads compress since the beginning of 2004.
Merrill’s National Municipal Fund has a duration of 5.25 years -- slightly below its peer group average of 5.5 years. O’Connor says he will shift to a more aggressive posture after the next one or two Federal Reserve interest rate hikes.
As muni bond yields have narrowed, O’Connor has sold some of the fund’s weaker corporate-backed industrial development bonds, pollution control bonds and tobacco bonds (like Golden State Tobacco’s), whose yields looked too low to compensate for their credit risk. “At this point,” O’Connor says, “we are not getting paid to take incremental credit risk.”
In place of the corporate-backed issues, he’s added a roughly 6 percent position in land-secured bonds. Issued by municipalities to finance infrastructure development for real estate projects, these bonds are secured by a special assessment tax that, initially, is the liability of the real estate developer. The bonds, though generally not rated, are comparable in credit quality to double-B-rated bonds, and yield between 80 and 150 basis points more than triple-A-rated muni bonds.
“These securities have very low duration characteristics,” O’Connor says. “They fit perfectly with our current strategy of keeping average coupons high and exposure to interest rates low.”
Steven Permut, who is manager of the $203 million-in-assets American Century High Yield Municipal Fund, is another believer in land-secured bonds, which he began to acquire in 1995. But he cautions that they represent fairly high credit risk, at least at first, because the ownership of the underlying property is concentrated among a handful of developers. “We need to do rigorous credit research and carefully monitor these projects,” Permut says.
Once the homes are built, and ownership is transferred to a diversified pool of homeowners who take responsibility for paying the special assessment tax, the risk associated with these bonds is dramatically reduced. At that point, they are customarily refinanced, and the resulting bonds are often backed by U.S. Treasuries, making for a significant credit upgrade and substantial price appreciation.
For example, on October 29, 1999, Permut bought the Orange County Community Facilities District (Ladera Ranch, Phase 1) 6.70 percent Special Tax Bonds maturing in 2029. The bonds were rated below investment grade. In 2005, however, after the homes had been built and sold, the bonds were advance-refunded and collateralized by Treasury bonds, and became comparable in credit quality to triple-A-rated bonds.
“This is where we get our biggest bang for the buck,” says Permut. The fund’s total return on the bonds, which Permut still owns, was 53 percent as of December 15, 2005.
The Saybrook Municipal Relative Value Fund, a Santa Monica, Californiabased hedge fund that has attracted $165 million in assets since its launch on July 1, 2004, looks for value in the lowest tier of the investment-grade muni universe.
“The majority of municipal bond investors focus on the high-grade or the high-yield segments and ignore everything in between,” says Saybrook chief investment officer Jon Schotz. “We use our expertise in credit analysis to exploit opportunities in this overlooked market segment.”
A typical trade for Saybrook and other hedge funds in the muni market: taking a long position in securities identified as underpriced, hedging the associated interest rate risk and capturing the price appreciation as the bonds become fairly valued.
Typically, between 10 and 20 percent of the Saybrook portfolio consists of below-investment-grade bonds. “Our expertise is taking credit risk, not interest rate risk,” Schotz says. The fund’s net duration runs between 1.5 and 2.5 years; it is currently 1.7 years. Triet Nguyen, the fund’s manager, attempts to enhance the fund’s return with a moderate degree of leverage -- generally, by a factor of two to three.
Thomas Kenny and Ben Barber, who comanage the $4.9 billion Goldman Sachs High Yield Municipal Fund, also find the greatest inefficiencies in pricing in the lower tiers of investment-grade munis.
The fund tends to emphasize the triple-B to double-B segment, which, according to Kenny, is generally the most inefficient part of the municipal bond market. “This is where we most often get the biggest pickup in reward for the smallest incremental amount of risk,” he says. A significant part of the demand for municipal bonds comes from the individual investor, and, adds Barber, “this type of investor doesn’t have the expertise to go down the credit spectrum and tends to stay in the double-A and triple-A portion of the market.”
The fund’s airline bonds, about 8.5 percent of assets, consist primarily of airport authority leaseback securities yielding between 6.5 and 9 percent. The bonds are secured by lease agreements on airport buildings and other assets.
“Investing in these bonds requires a lot of homework,” Kenny says. In addition to basic credit analysis, “we have to do a lot of legal analysis to fully understand the lease agreements, which can be quite complex.”
The portfolio managers’ homework has paid off: The fund has underweighted the lease-backedbonds secured by Delta Air Lines, Northwest Airlines and United Airlines -- companies that filed for bankruptcy -- while emphasizing issues of Continental Airlines and American Airlines, the industry’s two big survivors. These holdings have helped the fund rack up an impressive 7.77 percent average annual return over the five years ended November 18, 2005, compared with a 6.24 percent return for the average Morninsgtar municipal bond fund.
Given the dramatic tightening in credit spreads over the past 18 months, high-yield municipal bonds are unlikely to see significant price appreciation over the next year. But the funds’ high-coupon income offers a safe haven from a continued rise in interest rates. “Right now,” says Merrill’s O’Connor, “coupon accrual is everything.”
