Municipal bond funds hunkered down into defensive, intermediate positions during the first quarter of 2002 to shield their portfolios from rising short-term interest rates.
The general municipal debt fund category tracked by Lipper Inc. nevertheless managed a 0.79% average total return during the quarter, despite losses of 39 to 55 basis points from one to five years and six basis points from 10 to 30 years on the Municipal Market Data triple-A yield curve scale.
Many funds even found opportunities during the quarter, primarily in inverse floaters and airline bonds.
"It was a rotten game," trying to pick investments that would best limit losses, according to Walter O'Connor, a director and senior portfolio manager at Merrill Lynch & Co. However, he added, being that as fixed-income portfolio managers are beholden to interest rates, they had little choice during the quarter.
O'Connor cited his Merrill Lynch national municipal bond fund's average duration of 5.8 to six years as a central reason as to why the fund was able to stay out of trouble in the volatile first quarter. A secret to O'Connor's success was a 17% weighting in inverse floaters, which helped the fund's A-class shares rank an impressive 12th out of 289 share classes in its general municipal debt fund Lipper peer group.
Amid the volatility of interest rates during the fourth quarter, inverse floaters worked for O'Connor and other fund managers, as they were able to profit from the still steep yield curve by hedging against the risks posed by leveraging.
Although the Oppenheimer Rochester National Municipals high-yield fund is close to its 35% prospectus limit on leverage, portfolio manager Ronald H. Fielding, a senior vice president at OppenheimerFunds Inc., said he has managed to offset the risk of the inverse floaters that the fund is invested in.
"We have offset the volatility by buying a lot of predominantly investment grade high coupon cushion bonds with call risk," Fielding said. "It introduces another kind of risk, but the two risks offset each other."
Both Fielding and O'Connor use the inverse floaters as a way of boosting their funds' returns, so they can preserve credit quality.
Fielding's fund is only 40% invested in non-investment-grade securities, but by picking up airline bonds at depressed levels in the post-Sept. 11 market, he was also able to boost his fund's performance. The fund ranked 10th during the quarter among the 75 high-yield municipal bond funds, according to Lipper.
Market participants reported a strong resurgence in bids for airline bonds during the first quarter. While the Lehman Municipal Bond Index registered a 0.94% overall total return for the quarter, the transportation sector, which is largely dominated by airline bonds, had a total return of 6.05%, said Peter DeGroot, municipal bond strategist at Lehman Brothers.
John Miller, portfolio manager of Nuveen Investments' top-ranked high-yield municipal bond fund also attributed that fund's performance in part to airline bonds picked up in the wake of the terrorist hijackings. The Nuveen fund's R-share class had a total return of 2.51% during the quarter, the highest of any municipal bond fund.
The recovering airline sector also helped investment grade funds. Paul Disdier, director of the municipal fund division at Dreyfus Corp., said airline bonds helped his firm's investment-grade muni fund to achieve the second-best performance of any mutual fund in its peer group, behind various share classes of PIMCO Advisors' municipal fund.
During the fourth quarter, the Dreyfus fund's weighting in airline bonds did not pay off, however, when it ranked 271 out of the 282 funds in its Lipper peer group.
The CDC Nvest Municipal Income Fund experienced a similar plight, after entering the fourth quarter with a 5% weighting in airline bonds. The fund's total return ranking rose to 11th place among its peer group for the first quarter, after ending the fourth ranked 273.
