Fund managers that were willing to make bets on the long end of the market or take on extra credit risk gained the most value in 2005, soaring past many shorter-term funds, according to Lipper Inc.’s annual municipal bond mutual fund rankings.
In 2005, the Federal Reserve Board’s tightening of monetary policy resulted in sharp increases in short-term municipal interest rates between two and five years, while the long-end of the yield curve actually fell as much as 22 basis points.
High-yield funds were the leaders of the pack as credit quality of some bonds improved and demand for higher yields amid the prevailing low interest rate environment drove the prices for such securities higher. Lipper’s high-yield municipal debt fund category had an average 6.04% total return for the year.
The general municipal debt fund category, by contrast, returned an average of 3.00% in 2005, which was its worst performance since incurring an average loss of 4.70% in 1999.
Other categories, such as insured and intermediate funds, returned 2.56% and 1.62%, respectively. Trailing those funds were short and short-intermediate categories, which respectively returned just 1.42% and 1.06%.
“It was a year where risk-takers got rewarded, so the more duration risk and credit risk you took the more you got paid,” said George Strickland, a managing director and portfolio manager at Thornburg Investment Management in Albuquerque.“Performance this year was largely driven by where you were on the yield curve — the further out you were, the better you did,” Strickland said. “We probably would have done a little better if we would have traded down in quality and bought sub-investment-grade bonds, but that is not our approach,” he added.
While the institutional share class of Strickland’s $1.3 billion Thornburg Limited Term Municipal Fund ranked fourth in the short-intermediate category, it still only returned 1.52%. The fund maintained an average maturity of four years and was overweighted in the health care sector and local general obligation bonds, much of which was high quality.
HIGH-YIELD HELP
Those that achieved top performance in the high-yield and general municipal debt categories did so with a number of strategies and approaches, but several managers said one key was an overweighting in the tobacco sector, which benefited from a number of prerefundings and the favorable outcome of litigation for the tobacco industry.
In December, the Illinois Supreme Court overturned a $10.1 billion judgment against Philip Morris USA by a trial court in 2003 that had initially spurred a slew of rating downgrades.
Tom Metzold, a vice president and portfolio manager at Eaton Vance Management in Boston, said tobacco was one sector that helped four separate share classes of his $2.8 billion Eaton Vance National Municipal Fund to score in the top 10 of Lipper’s general municipal debt fund category, which is a universe of 269 share classes.
The institutional shares of that fund snared the number one ranking, with a total return of 7.97%. The fund, meanwhile, brought in between $400 and $500 million in new cash flow throughout the year, he said.
However, Metzold said he avoids forecasting interest rate or sector moves, or sticking to one specific strategy for any length of time.
“Our trading gains were all over the board,” Metzold said.
He noted that he participated in various credits and sectors that offered relative value on a given day, as deemed attractive by his staff of traders and credit analysts. “They were the eyes and ears of the fund, and an integral part of the overall process,” he said.
“We don’t like to marry ourselves to a particular strategy in a dynamic market environment,” he said. “What we like to do is take advantage of opportunities that often result from overreactions based on credit developments that are temporary.”
“There is nothing that is our favorite sector or unfavorite sector,” he added. “Everything has potential based on price, yield, and its relative value.”
Dan Loughran, a vice president and portfolio manager at OppenheimerFunds Inc. in Rochester, N.Y., said the $1.2 billion Oppenheimer AMT-Free National Fund he manages maintained a 4.6% exposure in 2005 to tobacco bonds that helped boost performance.
The spread on tobacco bonds narrowed between 50 to 100 basis points depending on the maturity and structure of the bonds, according to traders.
The Oppenheimer fund’s A-class shares achieved a 7.83% one-year total return and ranked in the number two spot in the general municipal debt category behind the institutional shares of the Eaton Vance fund.
“We had the advantage of getting strong performance from lower-rated credits, which outperformed because credit spreads continued to narrow throughout the year,” Loughran said.
The fund maintained 12.5% of its holdings in the education sector, which made up its largest weighting, followed by 11% in special assessment bonds, 10% in health care, and 4.3% in airline bonds.
“Your yield was the more critical component of total return than price change for most funds,” he said.
Another strategy Loughran said he used was to buy high-coupon, premium bonds with long-term maturities that were priced to a shorter call date. “They have less interest-rate sensitivity than par bonds or discount bonds, and when prices are falling they give you more protection on the downside,” he explained. They also offer attractive yields, he said.
Lyle Fitterer, head of customized fixed income at Wells Capital Management, said he increased tobacco exposure to between 4% and 5% in the $385 million Wells Fargo Advantage Municipal Bond Fund in 2005, from just 3% to 3.5% in 2004.
“We like the sector and the trends were favorable so we took up our position,” said Fitterer, who is based in Menomonee Falls, Wis., where he co-manages the fund with Duane McAllister.
For example, Fitterer said he added to a position he already owned of tobacco bonds issued by the Badger Tobacco Asset Securitization Corp. in Wisconsin by buying the 6% coupon bonds due in 2017, bringing his holdings in that credit to 2%. The bonds — which are rated Ba3 by Moody’s Investors Service, and BBB by both Standard & Poor’s and Fitch Ratings — are currently yielding a little over 5% in the secondary market, and Fitterer said he plans to continue holding the bonds for their continued high performance value.
The Wells fund scored a 5.03% total return for the year and ranked 10th among general municipal debt funds, according to Lipper.
Fitterer also said he found value in the zero-coupon market, where spreads tightened during the year. Triple-A rated 20-year zero coupon bonds that were yielding 85 basis points more than the generic triple-A scale tightened to within 60 to 65 basis points in the latter part of the year.
The fund also reaped the rewards of owning some bonds that were prerefunded because of their price appreciation, and then became secured by triple-A rated U.S. government securities.
One such bond issued by the Colorado Educational & Cultural Facilities Authority on behalf of the Bromley East Charter Co. for a charter school with a 7 1/4% coupon and a 2030 final maturity that got prerefunded to a 2011 call date.
The fund owned about a 1% position in the bonds, which were insured XL Capital Assurance. The price of the bonds shot up to $120 after they were prerefunded, from $104, while their yield dropped 275 basis points to 3.65%, according to Fitterer.
In addition to the tobacco sector, bonds backed by American Airlines and Continental Airlines helped propel the Goldman Sachs High Yield Municipal Fund to a high ranking during the year, as the carriers benefited from cost-cutting measures put in place, according to Ben Barber, a portfolio manager at Goldman Sachs Asset Management in New York.
Another sector that helped the Goldman fund during the year included bonds sold for residential real estate developments backed by special assessments levied on property. While municipal bonds sold for such developments are most common in California and Florida, other states where they originate can include Nevada, Arizona, South Carolina, and Virginia.
The land appreciated in value, and in recent years there was a lot of consolidation among the developers who are responsible to make debt service payments during the initial riskier stage before the properties have been sold, according to Barber.
“Now you have developers that have very large balance sheets that have very deep pockets in today’s market, versus previous markets, say, five or ten years ago,” he said.
Other investments that benefited the fund included primary care hospitals based on an analysis of their financial positions, management profile, and competition in their service area, according to Barber.
The Goldman fund’s largest share class, which is reserved for institutional investors, had a total return of 7.72% during the year, according to Lipper. The fund is often not open to new investors so that it is not forced to invest during inopportune periods, another factor which helped the fund in 2005, Barber said.
At the bottom of the high-yield category was the Evergreen Strategic Municipal Bond Fund, largely because portfolio manager B. Clark Stamper has strategically shifted much of the fund’s assets out of the high-yield sector in recent years.
The fund’s average credit rating is double-A-plus.
Stamper, who is president of Stamper Capital and Investments Inc. in Corona Del Mar, Calif., and manages the fund through a subadvisory agreement with Evergreen Funds, said he believes many high-yield bonds are currently overvalued, and that prices “could drop a lot.”
Instead of taking on credit risk, Stamper has focused on high-coupon bonds approaching their call dates that are less sensitive to interest rate movements similar to Loughran’s strategy. Because of the uncertainty over whether such bonds will indeed be called or not, they offer an additional 10 to 40 basis points in yield, he said. And Stamper said he has a knack for picking out those that won’t end up being called, and are therefore priced incorrectly.
The fund is also about 10% to 15% invested in 35-day floating-rate securities, which maintain stable prices in the face of rising interest rates.
As a result, Stamper’s fund has a duration of around two years, although the 3.23% total return of its A-class shares were better than any fund in Lipper’s short-term category, which averaged just 1.42%.
THE DURATION GAME
Funds without much high-yield exposure in Lipper’s general fund category did well by focusing on longer-term bonds, which rose in price as their yields fell somewhat during the year.
The Mosaic Tax-Free National Fund — which mostly owns intermediate-term bonds — found itself near the bottom of the general fund category, with a total return of just 0.99% for the year.
“The long bond really outshined everything else by quite a big margin,” said Michael Peters, portfolio manager at Madison Investment Advisors in Madison, Wis., who runs the fund. “If you didn’t own the long end of the market, you really didn’t get a whole lot of return, and that’s kind of been our case.”
“It was a duration game,” said Bob Crowell, executive vice president and portfolio manager at Pacific Capital Funds in Honolulu.
However, the $70 million Pacific Capital Tax-Free Short-Intermediate Fund that Crowell manages only had a limited opportunity to extend out the curve due to prospectus limitations. The Y-shares of Crowell’s fund achieved a 0.87% total return.
Some investors, like Mike Pietronico, a portfolio manager at Evergreen in Charlotte, found success in the 12- to 15-year maturity range where the yield curve was relatively steep, and less vulnerable than shorter-term maturities to rising rates.
“With short rates moving more quickly than intermediate and long rates, the 15-year market, give or take a few basis points, was relatively unchanged,” he explained. “That was an area that we felt was a defensive spot on the yield curve to maintain a high level of income,” he added.
Another strategy that Pietronico said differentiated the $551 million Evergreen Intermediate Municipal Bond Fund he runs from its peers was buying 4.50% and 4.75% coupon bonds in the 15-year range of the curve at a time when many of his peers preferred 5% coupon bonds. “We were able to pick up 15 to 20 basis points in incremental yield with those coupons in what we thought was going to be a low-volatility environment and it was,” he said.
The strategy worked as planned. The I-class shares of the fund ranked second among intermediate funds, with a 3.48% return, according to Lipper.
Pietronico also said he overweighted his fund with California school district bonds, which he said were “trading way too cheap to their intrinsic value in that part of the curve.”
Pietronico also found value from buying single-family housing bonds that were not subject to the alternative minimum tax. “Some of the bonds are undervalued relative to those pre-payment concerns and they tend to trade at higher yields to compensate for the reinvestment risk,” he said.
The fund manager said he was frequently able to find a better selection and better yield levels in the secondary market rather than the primary, since many new issues were oversubscribed by crossover buyers and hedge funds, whereas the secondary market often has product that is not as widely held by many of those accounts.
In addition, many new issues are often put out for the bid a day or two after the original deal prices by dealers looking to see if the bonds will trade up in the after-market, which “diminishes the trading value over time,” he said. In the secondary market, “bonds tend to trade better when you eventually put them out for the bid just because of the scarcity value involved,” Pietronico added.
In retrospect, Pietronico said he has no regrets about missing out on opportunities other managers explored in the high-yield sector, and plans to approach the coming year with the same quality cautiousness that he maintained in 2005 by limiting his exposure to credits rated below single A.
“The Fed is 13 tightenings through its cycle with one or two left, and is trying to slow the economy down,” he said. “With that in mind, there is going to be some credit pressure that seeps into the market, and I am trying to avoid gyrations in general in overall creditworthiness.”
Besides the strong performance in its peer group, Pietronico said his fund experienced a 20% year-over-year growth due to strong positive cash flow in what was one of its strongest years of performance recently, he said.
Jacob Fine contributed to this story.
