Only a smattering of municipal bond mutual funds have managed to eke out positive total returns since mid-year, and the top five all have one thing in common -- Joe Deane, a managing director at Citigroup Asset Management Inc. in New York, structured their portfolios to lessen the impact of rising interest rates.
The stance Deane took was a painful one during the first half of the year, as municipal bond yields plummeted to lows not witnessed in decades. Deane had reduced his five funds' sensitivity to interest rates and hedged them against a rise, causing their performance at first to slip to the near bottom of their respective Lipper Inc. categories.
But the cautious approach has paid off dramatically since municipal bond yields ascended this quarter. Only 10 municipal bond funds are so far producing positive total returns for the quarter, based on an analysis of the largest share classes for each fund, according to Lipper. The average share class experienced a loss of 2.94%.
Leading the pack on the positive side is Deane's Smith Barney Arizona Municipals fund, its A-class shares having produced a total return gain of 1.67% since the start of the quarter. The average Arizona fund, by contrast, is down 2.91%.
The return produced by the fund this quarter has propelled its total return for the year to date to 2.79%, also the best in the category. During the first half, its 1.11% return ranked dead last among Arizona funds.
The second-best muni fund this quarter, according to the Lipper analysis, is the Smith Barney New Jersey Municipals fund, with a total return of 0.87%. The Smith Barney New York Municipals fund and the non-state-specific Smith Barney Managed Municipals Fund are the third- and fourth-best performers overall, with total returns of 0.59% and 0.38%, respectively.
While California funds have suffered because of the state's political and budgetary troubles, the Smith Barney California Municipals fund has managed to produce a total return of 0.30% this quarter, making it the fifth-best muni fund overall. The average California fund is down 3.68% since mid-year.
The California fund's secret is an aversion to bonds whose credit is somehow related to that of the state, according to Deane. The fund has only a tiny position in California general obligation bonds, and most of its holdings are essential-service revenue bonds, he said.
The only other funds whose largest share classes produced positive returns since mid-year include South Dakota and North Dakota funds run by the Minot, N.D.-based Integrity Mutual Funds Inc., a Colorado fund run by Freedom Funds Management Co. in Denver, a short-term fund run by the Milwaukee-based Strong Financial Corp. and a national fund run by Calvert in Bethesda, Md.
The Smith Barney funds have been buoyed to the top not by sector-specific credit calls but rather by a consistent strategy applied to all the funds that has allowed them to perform well even as bond prices have eroded.
Deane has adopted a strict diet for the funds, requiring higher stakes in cash, so that they own fewer bonds on which to take principal losses.
The funds can't own any zero-coupon bonds. Because they don't bear any returns until they mature, zeros are said to be more long-term -- and thus more interest-rate-sensitive -- than bonds with identical maturity dates that make periodic interest payments.
Bonds with coupons below 5% are also out of the question, because they will be difficult to trade in a higher-interest-rate environment, according to Deane. So are any bonds trading at discounts to their face value.
Discount bonds can "sink like a stone" when interest rates rise, Deane said. When the discounts bonds trade at in the secondary market reach a certain level, the bonds begin to trade at depressed prices, because the gains a buyer would realize when they mature at face value are federally taxable as ordinary income rather than at the lower capital-gains rate.
Instead, the funds are investing in short-term and high credit-quality bonds, which are less sensitive to interest rate changes, Deane said.
When rates rose in 1999, Deane had also shortened his portfolios and bulked up in cash. But following the infamous Long Term Capital Management hedge fund collapse, he opted not to use futures contracts. Despite his defensive stance, share classes of Deane's Managed Municipals fund showed up at the very bottom of the Lipper rankings by the end of 1999 and the funds' assets were left depleted by almost $1 billion.
This time, Deane said he is using futures contracts to offset losses. So far, cash flow has been steady, he said. "We just wanted to have the most liquid and the most conservatively positioned funds we could get our hands on," Deane said. Interest rates seemed too low based on the state of the U.S. economy, he added.
"We just felt that when the marketplace broke from the levels that they drove it to, that this was going to be one of the all-time great down-trades in the history of the down market, which it turned out to be," Deane said.
Over a period of nine weeks starting June 12, The Bond Buyer 20-Bond Index rose from 4.21% -- its lowest level since 1968 -- to 5.18% on Aug. 14. The 23% rise was the largest percentage increase in the index level in 16 years. Historically, there have only been three periods in which the index has risen so much over such a short span of time since The Bond Buyer began tracking the index on a weekly basis in 1946. Those percentage increases occurred in 1987, 1980, and 1951, and the largest of these was in 1980 when the index rose 24.4%, to 9.44% on March 27 from 7.33% on Jan. 24.
"Once the market started going down, you were either defensively positioned or you were just run over," Deane said.
Many portfolio managers have been performing a balancing act as they try to continue providing income for their shareholders while limiting the price volatility of their funds, said Craig Vanucci, a director of fixed income at B.C. Ziegler & Co. in Milwaukee. Many investors buy shares specifically for the income they produce, he said.
For that reason, Deane believes rising interest rates may be beneficial to the market over the long run.
The funds have recently been struggling to attract capital, and higher interest rates may make them a "very, very attractive area for people to look at again," Deane said. By stocking up on cash, his approach will allow his funds to reinvest and benefit from those higher rates that much more quickly.
"We don't think the down market's over -- we think it's just started," Deane said. He predicts the century's first great bear market in bonds could last until the end of 2004.
