Most municipal bond mutual funds suffered losses during the third quarter as short- and intermediate-term interest rates rose and airline bond prices plummeted because of bankruptcy filings by two major carriers.
"You are not doing very well if you have bonds in that 10-to-17-year part of the curve, which continues to take the bulk of the hits in here," said Michael Peters, a principal at Madison Investment Advisors Inc. in Wisconsin.
"We have been short as a firm for a long time, thinking that rates are going to rise, and that really hasn't played out for several years," said Peters, who helps manage the $22 million Mosaic Tax-Free National Fund.
The fund ranked near the bottom of the general municipal debt fund category tracked by Lipper Inc. with a negative 0.67% total return during the third quarter. However, most funds did not fare much better, as the average total return for the category was a negative 0.17% for the quarter.
"If you had longer bonds out the curve -- 20 to 30 years -- you did OK because that sector still seems to be performing pretty well, even though the market overall had a negative total return for the quarter," Peters said.
"We have virtually no exposure 20 years on out," he added. "It has been a little bit frustrating for us."
Yields on 10-year triple-A rated general obligation bonds rose 25 basis points during the third quarter to 3.73% on Sept. 30, according to Municipal Market Data.
Still, the funds continued to take in money, as they had a $4 billion net inflow during the first two months of the quarter, the Investment Company Institute reported. September figures have not yet been released.
Filings for protection last month by Delta Air Lines and Northwest Airlines under Chapter 11 of the U.S. bankruptcy code hurt the performance of funds that owned their bonds.
Peter Coffey, portfolio manager of the Smith Barney Municipal Fund National Portfolio at Citigroup Asset Management Inc. in New York, sold off its holdings backed by both Delta and Northwest early in the quarter, helping the fund's performance.
The largest share class of the fund produced a 1.47% total return during the quarter, making it the top performer in Lipper's general municipal fund category.
However, the Smith Barney national fund did own some bonds backed by Continental Airlines and American Airlines, which were still a drag on its performance as the entire sector suffered, according to Coffey.
Bonds owned by the fund that performed well were those backed by hospitals and the 1998 landmark settlement between most states and the tobacco industry, according to Coffey.
The tobacco sector performed favorably during the quarter, as some deals were prerefunded and investors sought out bonds for the higher yields they offered.
The Oppenheimer AMT-Free Municipals fund benefited from its holdings in the sector, according to Scott Cottier, a vice president and portfolio manager at OppenheimerFunds Inc. in Rochester, N.Y.
The fund's largest share class produced a 0.63% total return during the quarter, ranking near the top of Lipper's general fund category.
The fund's hefty weighting in lower investment-grade paper helped in general, as credit spreads continued to contract, according to Cottier.
"You had relatively stable long-term interest rates. You have had tightening credit spreads throughout the spectrum -- from A-rated all the way down to the bottom of the barrel nonrated or single-B credits," he said.
The spread between yields on 10-year triple-A rated GOs and 10-year triple-B rated GOs narrowed eight basis points to 66 basis points during the quarter, according to MMD.
Overall, high-yield muni funds were the best performers as the average fund in that category produced a 0.54% total return during the third quarter.
The largest share class in the Smith Barney Municipal High Income fund topped the category with a 3.08% total return.
The fund was aided by its hedge against rising interest rates with futures contracts, according to Coffey. The fund also capitalized on the tightened credit spreads by selling some of its holdings, he said.
The fund benefited from housing bonds with property previously valued at depressed levels but now being sold for more.
All three share classes in the Oppenheimer Rochester National Municipals fund ranked at the bottom of Lipper's high-yield muni fund category with significantly higher losses than any of its competitors. The largest share class in the fund produced a negative 1.68% total return, while the next worst performing fund in the category was the Franklin Tax-Free High Income Fund, which had a negative 0.39% total return.
"The fund currently owns secured debt backed by Delta and Northwest," Cottier said. "The market reacted negatively to the bankruptcy filings and bonds backed by those two airlines were negatively affected."
"The performance of the airline sector was the single driver that caused that fund to underperform during the quarter," he added.
Oppenheimer fund managers did anticipate the bankruptcy filings, but are confident the secured Northwest and Delta debt they to hold will continue to see payments because they are backed by specific assets such as gates, cargo, and maintenance facilities, which they believe will be vital to the airlines' operations after they emerge from bankruptcy, according to Cottier. (c) 2005 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com
