Quick turnover investing in highly callable bonds has helped Banc One Investment Advisors Inc. kill two birds with one stone, according to Patrick M. Morrissey, a Banc One vice-president and portfolio manager.
"The objective of the One Group Tax-Free Bond Fund is to generate very high income while attempting to maintain a stable share price," he said.
He achieves this by investing in premium single-family mortgage revenue bonds and bonds with active sinking funds, he said.
The frequent calls mean the yields are high. And he copes with the uncertainty they create by using sophisticated analytical methods built up over his years at Banc One.
Complex though his approach is, Morrissey added that the goal is to create a fund that has exactly what a municipal investor should be looking for - capital security with plenty of income.
To pursue his strategy, Morrissey buys bonds at par. The pre-payment options on them ensures that the bonds will not appreciate much in value because of the likelihood of being called soon.
A prime example of this logic is his biggest holding, the Texas Department of Housing and Consumer Affairs supersinker bonds.
"Those are being called on a very frequent basis. I bought those to yield a 7.3% and they're being called very frequently at the accreted value so we have the price stability." he said.
"At the same time, I have a big block of bonds that's yielding 7.3% and with the 30-year Treasury at 6.45%, we're hitting some home runs," he added.
He expects to hold these bonds for the next two years - and hopes to build up his holding, if possible. When they are called he plans to re- invest in more of the same to maintain the level of income.
Sinking Fund
Another example of his use of sinking fund bonds is a batch of bonds he bought last Wednesday.
The bonds, Salix, Iowa, pollution control revenue bonds with a sinking- fund life of Dec. 1, 2001, and a Dec. 1 par call, provide a high yield of 5.75%. Their price is stable, he said, because investors fear they will be called.
But, Morrissey said: "They've been outstanding since 1973, so the likelihood of them being called in December is very remote."
He usually buys his bonds with the knowledge that the bonds will be called, however. "We know that the likelihood of a homeowner making mortgage payments over 30 years is very, very slight," he explained.
"People get transferred, people move, people sell their houses, houses burn down, you get insurance proceeds, therefore you get prepayments. Also when interest rates go down, the propensity of mortgage owners is to refinance."
"The worst-case scenario is when interest rates go down real sharply like they did a couple of years ago - we have to keep a surveillance on the prepayment likelihood of these bonds and adjust our amortization schedule and make sure that we're not overpaying income," he added.
Meanwhile, he said this year's plunging prepayment rates are "a real good thing," because it means issuers are calling bonds at a slower rate than previously.
Amortizing Premiums
He explained: "If I buy a bond at, say, a premium price of 110 and I think it has a five-year average life, then I want to amortize 10 points of premium over five years, which is two points a year.
"You get to year four and it's getting very obvious that the call is not five years from when we bought it but more like seven or eight, we're going to still amortize our premium down to our original expectations, which is a conservative approach."
He structures the tax-free bond portfolio by buying bonds with at least a two-year call protection, he said. "The real key to the way this fund works is that in the premium housing bonds that we buy, we come up with an estimated average life," he added.
Morrissey, who said that he had refined the technique of choosing bonds and timing the calls over a period of seven or eight years, declined to elaborate on how he does it.
He said Banc One has developed its own internal systems to attempt to predict the likelihood that bonds will be called.
The system has worked well, he said, adding that calls generally occur near the times predicted. He said, however: "We have found that it is to our advantage to estimate an average life to be shorter rather than longer, because what we're doing is amortizing that premium down much quicker and the end result is that, if you come up with a shorter average life, then you get to that magical date and you've amortized all the premium away.
"Anything beyond that, it's all income to the portfolio," Morrissey said. He also said the seasoning of a mortgage pool gives clues as to when a SFMRB might be called.
$1 Million of Calls a Month
Morrissey times the way his bonds are called so he has a monthly cash flow to reinvest in new bonds with a minimum coupon of 6%.
He estimates that he receives between $800,000 and $1 million every month from calls. On top of that, he said, his fund has bucked this year's generally negative cash flows into municipal mutual funds by receiving on average $1.8 million a month from investors.
He attributes the cash flow to Banc One's effort to expand their existing funds.
The ability to perceive when calls are likely to occur, even with the less-predictable structures, means that Morrissey does not shun issues other buyers might avoid, he said.
An example is bonds that can be cross-called.
"It's labor intensive, and that's why other people shun these types of bonds," Morrissey said. "It's harder to figure out if these bonds are going to be called."
Issuers cross-call their bonds because it provides a rapid way to retire high-cost debt. But it is often hard to tell how likely a bond is going to be cross-called and investors often have to resort to a legal review to find out how much influence an issuer can exert in exercising the option.
Avoiding Junk
Morrissey said many of his single-family housing bonds have been upgraded even while much of the sector has suffered downgrades to junk status.
"A good portion, probably 20% of the portfolio or more is triple-A rated by virtue of Ginnie Mae or Fannie Mae," he said, referring to the Government National Mortgage Association and the Federal National Mortgage Association.
"I have experienced a significant amount of upgrades during the year, so even though the credit rating is not real high on the list of what we look at" when considering whether to buy securities, it does play a part in his decision-making, he said.
Morrissey's income-generating objective dovetails with Banc One's asset allocation strategy.
He believes stocks are a better total-return vehicle, so he runs the tax-free bond fund for income rather then total return, assuming that investors are relying on their equity holdings for capital appreciation.
"We know that if our customers want to maximize their net worth over a long period of time, they're better off in stocks, and when we do our balances and asset allocation we use the tax-free bond fund as an income generator and not for capital growth," he said.
"We're trying to generate tax-free income - why would we want to maximize the share price and generate capital gains?" Morrissey said.
Like Shooting Yourself In the Foot
"It's just like shooting yourself in the foot," he continued.
"What's really interesting this year, is going to be the market discount rule.
"A lot of the funds bought the long, deep discount bonds. When those bonds are sold, and the shareholders are handed an ordinary (taxable) income and not capital gains at the end of the year, there's going to be a lot of head scratching and wondering what's been going on" he predicted.
The market discount rule applies to bonds investors buy after April 30, 1993. The rule subjects nonoriginal-issue discount bonds to ordinary income tax rates - which are higher than capital gains tax rates - if the bonds appreciate more than the amount set by the de minimis ruling.
Morrissey characterized his fund as being one that features a contrarian bent. "Our definition of performance is more high income and stability whereas the rest of the mutual fund world measures performance by maximizing the share price," he said.
He added that his strategy of trying to maintain stability is also a defensive one. "We are less likely to lose money than long duration, long maturity bond funds," he said.
He compares his fund with long-term bond funds because he tries to achieve similarly high returns with a fund that is subject to less price volatility, he said.
Customer Survey
Morrissey picked up his housing bond expertise at the United Bank of Denver branch of Norwest Bank in Colorado.
In a 1987 market survey, the bank found share-price stability and quality were what investors most desired in a tax-free bond fund.
In an effort to find tax-free securities to satisfy the demands, Morrissey came up with a mix of housing bonds, student loan bonds, and bonds with sinking funds. Out of this potpourri, he created a new fund, he said.
Morrissey manages an intermediate tax-free bond portfolio as well as the housing-bond-filled tax-free bond portfolio.
But it is the latter that is his pride and joy because it is a rarer breed of mutual fund than the intermediate, he said.
He started the tax-free bond fund in February of 1993, the year when interest rates started falling.
It was not the best time to start the fund, he admitted. "It was quite interesting because not only was I under scrutiny because this was a new product and I had a lot of disbelievers, but it was the absolute worst-case scenario for this kind of fund," he said.
Strategy Proved
He believes that the positive inflow of cash into the fund this year is proof that he has succeeded in overcoming these obstacles.
And the current scarcity of intermediate bonds has affected him less than other managers, he claims, because of the sluggish behavior of housing bonds in a market rally - behavior that reduces investor demand.
"When you see a bond market rally, the first thing to be sold out of a portfolio is a housing bond because it won't run up in price so much because of the optional prepayment scenario," he said.
