As the subprime mortgage crisis unfolded in the latter part of 2007 and took its toll on the municipal market — specifically the bond insurance industry — one sector of tax-exempt mutual funds was quietly outperforming all other categories.
In the fourth quarter, in all of 2007, and even in two-year trailing returns, insured municipal debt funds performed better than all other categories, according to Lipper Inc. These funds are also benefitting from better inflows when compared to other muni fund categories, according to AMG Data Services.
Lipper reports that in the fourth quarter of 2007, cumulative total reinvested performance for the 53 insured muni funds with $11.2 billion of assets under management was 0.57%. For general muni debt funds — it tracks 248 funds with $82.3 billion of assets under management for this category — the return was 0.07%. For the 105 high-yield funds with $46.9 billion the return was negative 2.51%.
With solid performance compared to other categories, insured funds had better flows. AMG reported on Jan. 10 that the four-week moving average of inflows for insured municipal mutual funds was $4.8 million. The four-week moving average for all muni funds was an outflow of $593.7 million. On Dec. 5 the four-week moving average for insured funds was positive $9.2 million, whereas the same average for all funds was negative $156.5 million.
Some market participants were unclear as to why insured funds would outperform as subprime concerns found their way into the municipal market through bond insurer woes.
In November, it became clear that several of the large triple-A insurers, and the lower-rated insurers, ACA Financial Guaranty Corp. and Radian Asset Assurance, had large holdings of subprime debt. Since then, the market has largely ignored the insurance rating on many bonds while looking principally at the underlying rating, market participants said.
“It is all about the underlying credit when you are looking at bonds now, regardless of insurance,” said Monte Avery, portfolio manager of the Integrity Kansas Insured Intermediate Fund. “For us, we performed well because our underlyings are strong, many are double-A or higher.”
The Kansas-specific Integrity fund was the best performing insured fund for the quarter, the year and two-year returns, according to Lipper.
In fact, many mutual fund companies require their insured funds, via their prospectuses, to maintain high underlying ratings Jeff Tjornehoj of Lipper said. Typically a minimum of single-A or double is the threshold if the fund is required to have a minimum underlying rating.
Underlying credit aside, Clark Wagner, director of fixed income at First Investors Management Co., said he believes that while muni insurance struggled in the fourth quarter, nevertheless insurance benefits in a tight credit environment.
“The overriding theme for the fixed-income markets certainly over the past six months is the under performance of lower-quality bonds,” Wagner said. “So insured bonds are still insured, they are still triple-A. While there has been a lot of negative press, and it has impacted the prices on insured bonds, the under performance of insured bonds is small when compared to lower quality bonds, both in the muni market as well as other markets.”
Municipal Market Data shows just that. From July 4, 2007, to Jan. 14, 2008, the MMD yield scale for triple-B, general obligation bonds maturing in 10 years declined 18 basis points from 4.47% to 4.29%. In the same time span, the MMD yield scale for triple-A insured bonds with an underlying of at least single-A declined 68 basis points from 4.23% to 3.55%. The cost of insured bonds has increased significantly due to increased demand when compared to the lower-rated bonds.
It should be noted that absolute yield levels for most muni credits have decreased in this time span following the lead of Treasuries as investors seek safety from credit problems.
One other aspect mentioned by market participants was the shorter duration that insured funds tend to have. Duration is the weighted average maturity of a bond’s cash flows and is a good way to measure the sensitivity of a bond’s price to interest rate movements. Bob MacIntosh, co-director of Eaton Vance’s municipal bond group, said that insured funds tend to have shorter durations than the general category, and given overall yield volatility over the entire year, this would be a good thing for these funds.
To this, Avery pointed to the steepening yield curve as evidence that shorter durations are paying off right now.
“You have various factors including shorter duration, and solid underlyings, however I think the real story here is that even though the market is viewing insurance differently, it is still insurance and it puts an investor in better shape then if they were to buy triple-B rated paper,” Wagner said.
Wagner did say that this year First Investors will change their prospectuses for the insured muni funds to allow the managers to buy some uninsured paper.
“We don’t expect a triple-A insurer to get downgraded but we have to have some flexibility in the case of a doomsday scenario,” he said.