Sounding the alarm on muni funds with heavy non-rated-bond weightings

Four firms are managing high-yield municipal bond funds with more than 40% of their assets invested in non-rated bonds, a red flag for investors, according to a muni bond expert.

Invesco tops the list of the firms carrying non-rated bonds. More than 64% of the Invesco High Income Municipal Bond Fund Ticker:(AHMCX) and 61.3% of the Invesco Van Kampen High Yield Municipal Bond Fund Ticker:(ACTHX) are in such bonds, according to research provided by Morningstar Inc.

Nuveen Investments LLC’s High Yield Municipal Bond Fund Ticker:(NHMAX) has 46.9% in non-rated bonds, while Waddell & Reed’s Municipal High Income Fund Ticker:(UMUHX) has 44.9%, and OppenheimerFunds’ Rochester National Municipal Fund Ticker:(ORNAX) has 43%. (Click here to see the full list.)

“Anything above 40% is a red flag,” and “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.

Given the continuing headline risk in the muni bond market, funds with such large allocations to non-rated bonds risk having to meet massive redemptions and could get stuck with having to sell these less liquid bonds at lower prices, he said.

Because the bonds tend to be thinly traded, it can often be difficult to price them, experts said. This is a risk with all muni bonds but even more so for non-rated bonds, said Matt Fabian, managing director at Municipal Market Advisers.

“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.

The Wall Street Journal reported that the Securities and Exchange Commission is investigating whether muni bond fund managers are overstating the value of the riskiest bonds in their portfolios, thus misleading investors. As part of the investigation, the SEC is looking into funds’ holdings of non-rated bonds, according to reports.

Officials at Invesco, OppenheimerFunds and Waddell & Reed said that the SEC hasn’t contacted them as part of the probe.

Kathleen Cardoza, a Nuveen spokeswoman, declined to comment.

Kevin Callahan, an SEC spokesman, declined to comment about the investigation.

SMALL ISSUERS

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. The average size of these issuers is $21 million, according to Municipal Market Advisers.

Bonds also can 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 Invesco, Waddell & Reed, OppenheimerFunds and Federated Investors Inc. said that 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 vice president 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 agencies, said Michael Walls, a vice president and portfolio manager at Waddell & Reed. He said that ratings agencies “do a good job of giving a snapshot in a given period of time.”

But Mr. Walls said the agencies don’t conduct audits on a quarterly, let alone more frequent, basis.

For example, Waddell & Reed invests in a lot of muni bond issuers that finance construction in the life care field, such as nursing homes, and has a person on-site making sure that subcontractors are within their budgets and abiding by the proper construction guidelines, Mr. Walls said.

Similarly, Invesco has 33 analysts dedicated to muni bonds, Lyman Missimer, head of global cash management and municipals at Invesco, wrote in an e-mail.

POTENTIAL TROUBLE

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.

Muni bond funds have seen $25 billion in outflows over the past 14 weeks, due largely to fears about mass defaults in the muni bond market, according to Lipper FMI.

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, some in the industry 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 is why Federated Investors 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, vice president and portfolio manager at Federated. The firm’s Municipal High Yield Advantage Fund (FMNCX) has 35.32% in non-rated bonds.

“It’s always nice to have that cushion,” he said.

Liquidity is always an issue for the entire muni 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.

Although 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, observers 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 past 20 years, Mr. Willis said.

Invesco has overridden the third-party prices “rarely,” said Ivy McLemore, an Invesco spokesman.

In fact, Mr. Willis thinks 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 said, “I think 2008 would have been a much smoother ride.”

E-mail Jessica Toonkel at [email protected].