Muni funds with large chunks of non-rated bonds ‘a red flag’

Invesco Ltd., Nuveen Investments LLC and Waddell & Reed Financial Inc. are among seven firms managing high-yield funds with more than one-third of assets invested in non-rated bonds, a potential red flag for investors, according to experts.
More than 66% of Invesco’s High Income Municipal Bond Fund and 61.3% of the Invesco Van Kampen High Yield Municipal Bond Funds are in non-rated bonds, topping the list, according to Morningstar Inc.
Nuveen Investments LLC’s High Yield Municipal Bond Fund has 46.9% in non-rated bonds. Waddell & Reed’s Municipal High Income Fund and the firm’s Ivy Municipal High Income Fund have 44.9% and 39.15%, respectively, in non-rated bonds. OppenheimerFunds’ Rochester National Municipal Fund has 43% in non-rated bonds, and its Oppenheimer AMT-Free Municipals Fund has 38%. (See the ten funds with the largest chunks of non-rated bonds.)
“I would say that anything with more than 20% in non-rated bonds requires absolute confidence in the management team,” said Eric Jacobson, director of fixed-income research at Morningstar. “Anything above 40% is a red flag.”
Non-rated bonds tend to be small in size and thinly traded. The average size of these issuers is $21 million, according to Municipal Market Advisers. Given the continuing headline risk in the municipal bond market, funds with such large allocations to non-rated bonds risk having to meet massive redemptions and getting stuck with having to sell these less liquid, non-rated bonds at lower prices, Mr. Jacobson said.
Another trouble with these bonds is that since they tend to be thinly traded, it can often be difficult to price them, experts said. This is a risk with all municipal bonds but even more so for non-rated bonds, said Matt Fabian, managing director at MMA.
“When you have uncertainty about what the bonds are worth and managers reporting the value on the bonds, you need to make sure they aren’t exaggerating the value of the bonds,” Mr. Fabian said.
On Feb 18, The Wall Street Journal reported that the Securities and Exchange Commission is investigating whether municipal bond fund managers are overstating the value of the riskiest bonds in their portfolios, thus misleading investors. As part of the investigation, the agency is looking into funds’ holdings of non-rated bonds, according to reports.
Officials at OppenheimerFunds, Waddell & Reed and Invesco said the SEC has not contacted them as part of the probe. Kathleen Cardoza, a Nuveen spokeswoman, declined to comment. Kevin Callahan, an SEC spokesman, declined to comment on the investigation.
Non-rated bonds aren’t inherently bad. Often these issuers don’t apply for a rating, because it would be too expensive, given their size. Bonds can also be non-rated because they aren’t investment-grade or they have been pre-refunded.
“As long as advisers understand the funds’ diligence process on these bonds, they can be great opportunities,” said Alan Dalewitz, a senior vice president at Herbert J. Sims & Co. Inc.
Officials at Waddell & Reed, Federated Investors Inc., OppenheimerFunds and Invesco said they all have analysts devoted to researching bond issuers, and their research process includes continual monitoring as well as site visits to the issuers. Each of the firms assigns its own internal ratings to the bonds, and monitors those ratings, executives said.
“Our team of 10 credit analysts spend all of their time looking at non-rated deals,” said Troy Willis, a VP and senior portfolio manager of the Rochester funds at OppenheimerFunds. In many cases, the firm can do better research on the bonds than the ratings agency, said Michael Walls, VP and portfolio manager at Waddell & Reed. He noted that ratings agencies “do a good job of giving a snapshot in a given period of time.” But he added that the raters don’t conduct audits on a quarterly, let alone more frequent, basis.
For example, Waddell & Reed invests in a lot of life care municipal bond issuers and has a person on-site making sure subcontractors are within their budgets and abiding by the proper construction guidelines, Mr. Walls said.
Similarly, Invesco has 33 analysts dedicated to municipal bonds, Lyman Missimer, head of global cash management and municipals at Invesco, wrote in an e-mail.
But even firms with the most prudent diligence process can run into trouble if there is another run for the exits by muni fund investors, as there has been over the past few months.
Municipal bond funds have seen $25 billion in outflows over the past 14 weeks, according to Lipper FMI, due largely to fears about mass defaults in the municipal bond market.
And now with mass protests in Wisconsin and other states over budget cuts, as well as the recent news of the SEC investigation into muni bond funds, experts worry about an even bigger exodus. Just last week, Jeffrey Gundlach, founder of DoubleLine Capital LP, predicted a sell-off in munis.
“A manager’s analysis of the bonds in the portfolio can be 100% on,” Mr. Jacobson said, “but if shareholders bolt from a fund, that can drive down price and the funds have to lock in those losses.”
That’s why Federated tries to keep 25% in bonds with at least an A rating, 25% in triple-B and 50% in non-rated and investment-grade, said Lee Cunningham, VP and portfolio manager at Federated Investors. Federated’s Municipal High Yield Advantage Fund has 35.32% in non-rated bonds.
“It’s always nice to have that cushion,” Mr. Cunningham said.
Liquidity is always an issue for the entire municipal bond market, not just non-rated bonds, Mr. Walls said. “I would say I am probably at my limit” with regard to his funds’ allocation to non-rated bonds, he said.
While liquidity is a concern, buyers do still exist for non-rated bonds, Mr. Willis said. “There are people calling us every day asking if we would sell some of our non-rated bonds,” he said.
But liquidity concerns could mean added pressure on fund managers to tweak the pricing of the bonds in their portfolios, experts said.
“Advisers need to understand the process managers are using to price their bonds,” Mr. Fabian said.
Waddell & Reed relies on two third-party pricing services and never overrides that pricing, Mr. Walls said. OppenheimerFunds has overridden the pricing of its third-party services only 12 times in the last 20 years, Mr. Willis said. Invesco has overridden the third-party prices “rarely,” said Ivy McLemore, an Invesco spokesman.
In fact, Mr. Willis believes that the SEC’s fears about managers’ manipulating the pricing of the bonds in their portfolios are overblown. “If the municipal bond market was manipulating prices,” he noted, “I think 2008 would have been a much smoother ride.”

Related Topics: Morningstar Inc.